Some investment professionals encourage investors to diversify and balance their portfolios with bonds. But what are bonds, and what role can they play in your portfolio?
Bonds are typically considered a more conservative investment, and may play a role in the balancing act in investment portfolios. They can also deliver a reliable stream of income, particularly in retirement.
Bonds tend to be a more stable and predictable form of investing. Bonds may attempt to help you ride out the volatility that the stock markets tend to offer on a fairly regular basis, no matter which direction they might be headed.
Like stocks, bonds can run in cycles, but they’re less volatile. Bonds sometimes outperform stocks when a bear market hits, providing diversification for investors who are attempting to put together more balanced portfolios. And like stocks, they do carry an element of risk, so investors should carefully research a bond and its risk before investing.
Invest as a Lender, Not an Owner
Bonds are financial instruments issued by states and municipalities, the federal government, or corporations as a tool for raising debt. You, the investor, loan money to the issuer for a set amount of time at a variable or fixed rate. You receive periodic payments, and at maturity, you get your principal back.
“A coupon bond, in simplistic terms, is a bond that pays a set rate of interest, known as the coupon rate, on an annual basis to the holder,” says Perry Guarracino, director of fixed income at TD Ameritrade. “In years past, bond holders would receive physical bonds with coupons attached, which they would cut off—hence the old term ‘clipping a coupon’—and present to a bank for payment.”
One exception, though: a type of bond called a “zero-coupon bond” is designed to return the principal at maturity, but with no payments along the way. To compensate the investor, it’s sold at a discount. So, for example, you might buy a $1,000 face value zero-coupon bond for $700, and at maturity, you’ll receive the $1,000 face value.
Guarracino answers some basic questions about bonds:
How are bonds issued?
Bonds typically have a face value of $1,000, although a bond's price may change over its life. When you purchase a bond through a broker such as TD Ameritrade, you become the registered owner of the bond and the broker will credit interest payments—those are the coupon rates—and principal at maturity directly into your account. Paper bonds no longer exist today; it’s all done electronically.
What does “at maturity” mean?
All bonds have a set maturity date, which is when the principal amount, or the face value, will be paid in full. Bonds generally fall into short-, medium-, and long-term durations, and the time to maturity is usually set when the bond is issued.
How do bonds generate income?
There are two ways:
- Interest income. Income is generated from the set coupon rates; bonds typically pay interest twice a year.
- Potential rise in the price of the bond. Bond prices typically move in conjunction with interest rates, but in opposite directions. If, for example, you own a bond that pays a 4% coupon, and interest rates drop to 3%, the bond you're holding rises in value, and you can potentially sell your bond in the secondary market at a higher price than your original purchase price.
Of course, if interest rates rise, the bond you're holding loses value, and could result in a loss if sold prior to maturity. But it's important to note that changes in interest rates have no bearing on the interest paid on your bond. Unless the issuer defaults, if you hold it until maturity, you'll receive all of the coupon payments and your full principal.
How risky are bonds?
Bonds are often viewed as a less risky alternative to stocks, but that doesn’t mean they are risk-free. All bonds carry a degree of credit risk that the issuer might default. Ratings agencies evaluate the issuer’s ability to repay the bond and grade them accordingly. Though there are a number of such agencies, each with its own ratings classification system, Standard & Poor's, Moody's and Fitch Ratings are commonly referred to as the "Big Three."
- AAA (or Aaa, depending on the issuing agency) are the highest-quality, investment-grade bonds and are least likely to default. U.S. Treasury bonds are considered the safest. AA (or Aa) to A are still considered investment-grade ratings that are of high quality or strong. Basically, if a bond's rating begins with a capital "A," it's considered a high quality investment-grade bond.
- BBB (or Baa, depending on the rating agency) bonds are still considered investment-grade, but there may be more uncertainty regarding the issuer's ability to meet long-term financial obligations. Bonds rated BB/B and Ba/B are commonly referred to as "junk bonds" and are considered to be speculative.
- CCC/CC/C (or Caa/Ca, depending on the rating agency) carry an even higher risk of default, and are considered highly speculative. But these bonds are generally offered with very high interest rates, making them high-yield bonds.
- D or C ratings indicate bonds that are already in default.
Although all investments carry risks, coupon bonds can be less risky than stocks, and can potentially add balance and diversification to a portfolio.
Asset allocation and diversification do not eliminate the risk of experiencing investment losses.
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