When companies need to raise cash, they have a few choices to consider. Borrowing money from a bank in a traditional loan is always an option, but the bank gets to set the terms of the loan. The company could hold a stock offering and raise money through new shares, but then they’re diluting their ownership of the firm. Another alternative would be through issuing bonds, which function much like traditional loans with a few key exceptions. Read on to discover how and why you might invest in bonds.
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What is a Bond?
Companies aren’t the only entities issuing bonds. Governments also raise funds by issuing bonds of various durations. It works like this—the issuer sells the bond on the open market for a set price, i.e. $1000. This initial price is known as “par value,” and if you buy a bond and hold it until maturity, it’s the amount you’ll recoup.
Duration is another crucial component of a bond. This is the length of time until the bond reaches maturity, where the initial investment must be repaid to the bondholder. Some bonds like US Treasuries can have duration as long as 30 years.
Types of Bonds
Explore the primary types of bonds:
- Treasuries. The federal government sells bonds called treasuries, with durations ranging from one month to 30 years. U.S. Treasuries are considered safe assets since the federal government has never defaulted.
- Municipal Bonds. Another form of government debt, municipal bonds are issued by states to fund infrastructure projects and pay for various expenses. Municipal bonds are usually exempt from taxation and issuers have a very low risk of default.
- Corporate Bonds. Both private and public companies issue bonds to raise funds. While individual companies have a much higher risk of default than government entities, investors are rewarded for taking on that risk with higher coupon rates.
How Do Bonds Produce Returns?
Bonds have an interest rate which determines the amount of the “coupon.” The coupon is a periodic payment made to the bondholder, usually quarterly or bi-annually. For example, a $1000 bond with a 2-year maturity and a 5% interest rate would pay a coupon worth $50. After two years, the bondholder would receive their initial $1000 back.
Bonds also fluctuate in price when sold on the secondary market, which creates arbitrage opportunities. Price differs from par value since the parameters of the market may have changed since the bond was issued. Let’s say the company that issued the $1000 bond with a 5% coupon wants to issue more debt, only this time the $1000 bonds come with 6% coupons. Since a similar bond with a better interest rate is now available, the bonds with the 5% coupon will no longer fetch $1000 on the open market.
Risks Involved with Bonds
Contrary to popular opinion, bonds aren’t risk-free investments. Here are a few factors to consider before investing in bonds:
- Default Risk. Naturally, the biggest risk when buying a bond is that the issuer will become insolvent before the bond reaches maturity. When this happens, the bondholder is out of luck—the initial investment is likely gone. However, bondholders do get paid before stockholders in liquidation events.
- Interest Rate Risk. Bond prices are directly influenced by current interest rates. When interest rates rise, newly issued bonds become more valuable since the coupon rate is higher than the previously issued bonds. Since investors won’t pay the same price for a lesser coupon, the previously issued bonds will only be sold at a price below par value. Likewise, if interest rates decline, the older bonds will become more valuable since new issues will pay a lower coupon rate.
- Inflation Risk. Bondholders are subject to the risks posed by inflation, just like most other asset holders. When inflation rises, the purchasing power of bonds already being held diminishes. A bond with a 4% coupon won’t provide a good return if inflation rises 5%.
Role of Bonds in a Diversified Portfolio
Bonds still have a large role to play in a diversified portfolio for three main reasons.
First, unlike stocks, bonds are subject to much less volatility. Volatility is something that must be stomached for stockholders to see higher returns, but bondholders surrender a bit of those returns for more stability.
Over time, stocks will usually outperform bonds, but bonds are typically a low-risk way to generate better returns than cash.
The next reason to hold bonds—especially investment grade bonds—in a portfolio has to do with correlation. Bonds have a very low, and sometimes even negative correlation to stocks. So, what does this mean in plain English? It means that oftentimes when stocks are selling off, that money is moving into bonds in a “flight to safety”. This reduces the size of the hole the overall portfolio has to dig out of to get back to even.
Additionally, bonds provide something most stocks do not—a steady stream of income through coupon payments. Yes, some stocks pay dividends, but those dividends vary and are subject to cuts whenever the underlying company’s performance suffers. A coupon is guaranteed for the life of the bond as long as the issuer remains solvent and able to pay.
A 60/40 stock-to-bond portfolio used to be the rule of thumb for retirement savers, but the investing landscape has changed in the last few decades. However, bonds will always have at least a small place in your diversified portfolio due to lower volatility profile, low or negative correlation to stocks, and the steady coupon payment stream.
Work with an Independent Financial Advisor
We hope you see how and why you might invest in bonds. If you have any questions or are ready to invest, an experienced, truly independent financial advisor from Good Life Financial Advisors of NOVA can help you get started. Contact us today!
Disclosure
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
