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posted on 07 July 2016

Bonds - Are They For You?

by Russ Allen, Online Trading Academy Instructor

Article of the Week from Online Trading Academy

Our last article on investing was about diversification of your investment assets. Today, let's answer some questions you may have asked yourself: "What are bonds?" and "Should I be investing in Bonds?" If you haven't asked yourself these questions, you should, regardless of age or net worth. Not everyone will choose to use them, but everyone should know what they are choosing (or not).

Some investors, especially younger ones, have never had the visceral experience of having their net worth cut in half in a matter of weeks. This can happen if you invest all your assets in any one thing, no matter what that thing is. And stocks (and mutual funds, and most people's 401(k)s, and stock ETFs, and variable annuities, and variable life insurance policies, and anything else that is based on stocks) are all one thing. So we need to put at least part of our money in something else.

Last time we listed some items that are not in the stock category, including:

  • Cash (earning [tiny] interest with no market-based risk)

  • Bonds (earning interest with little risk, depending on selection)

  • Carefully selected insurance products like fixed annuities

  • Precious metals (volatile, but not synchronized with the stock market)

  • Commodities (also volatile, but will retain purchasing power in case of high inflation)

  • Real Estate

What Is a Bond?

Bonds are often more grandly known as "fixed-income investments." Even the most restrictive investing environments, which are 401(k)s and other employer pension plans, usually offer some way to invest in bonds.

What is a bond and are bonds good investments?

Bonds, and similar things including notes, bills and debentures, are debt securities. The investor lends money, and the borrower (the bond issuer) promises to pay it back with interest. Individual investors almost never lend money directly to the borrower. The investors acquire the bonds from a dealer or broker; or they buy mutual funds or exchange-traded funds which are pools of bonds.

When we own bonds directly or indirectly, we are owed a certain amount of money by some entity. That entity is contractually obligated to pay us that money (the face amount or face value of the bond, also called the principal amount) at some future date, called the maturity date. The borrowing entity may be a government unit (like the U.S. Treasury or the State of California or the Federal Republic of Germany), or it may be a corporation.

The "fixed income" label is because the borrower (the bond issuer) usually pays interest on the bonds at a fixed percentage of the bonds' face value per year. For example, a bond may have a face value of $1,000 and pay 4% of that, or $40, per year in interest. This percentage is called the coupon rate, from the days when bearer bonds actually had coupons attached which the owners clipped off and presented for payment.

Note to millennials: coupons were based on a technology called paper, which was a primitive means of storing and transmitting text in the days before screens.

There are exceptions to the literal fixed-income rule. The shortest-term debt issued by the U.S. Treasury, for example, does not pay interest. It is a form of zero-coupon security. The treasury bills are sold at a price less than their face amount and then repaid at face value. The investor's return is the difference between the discounted price paid and the face amount.

If we set aside a portion of our money for investing in bonds, it is out of reach of the stock market, and may provide a buffer in bad markets. It will also keep some cash coming in, in the form of interest. If bonds are our only non-stock-market alternative, as in an employer 401(k), we should seriously consider investing in bonds as a means of diversification.

How To Invest In Bonds

There are basically two ways of investing in bonds:

  1. We can buy mutual funds or exchange-traded funds that own pools of bonds. The fund passes on the interest to us. We can sell the shares in the fund at any time.

  2. We can buy bonds individually through a bond dealer and hold them until they mature. At that time the bonds are repaid at the face amount. Meanwhile we collect the interest.

Each of the above two methods of buying bonds has its advantages.

Advantages of Buying Bond Funds

  • Ability to invest small amounts at a time without tying up large amounts of capital.

  • Allows us to participate in bonds in a 401(k), or outside of it.

  • Allows us to conveniently buy or sell the bond investment at any time.

Disadvantages of Buying Bond Funds

  • On the downside for bond funds and ETFs, the price of the bond fund will fluctuate. We could end up having to sell the shares at a loss.

Advantages of Buying Bonds Individually

  • We can hold the bonds until they mature. We know how much we will be repaid (assuming the borrower can repay). We don't have to worry about fluctuations in the prices of the bonds. From our point of view, a $1,000 bond is always worth $1,000.

Disadvantages of Buying Bonds Individually

  • On the downside, if buying individual bonds we have to create our own diversification by investing in several different ones, as buying bonds individually is usually not economical unless we put at least several tens of thousands of dollars into each bond issue. This is because there are high dealer markups on individual bonds when bought in small amounts.

There's a lot more to say about bonds, but that's all we have space for today. For now, keep an open mind about investing in bonds and consider whether they should be a part of your master plan.

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