The essence of bonds investing
The main theme with income investing is to receive the coupon payments until maturity and to preserve capital. Basic income investing strategies are not concerned with capital gains, however there are specific bond investing strategies and even speculative bond strategies which do seek a realized capital gain.
There are a vast variety of reasons why investors seek the income provided by bonds. They include a short-term place to keep funds safe, saving for a home or college education and providing retirement income. The reasons themselves are not important and what they all have in common is that preservation of capital and an income is of utmost importance. These investors may also have stocks in their portfolio and the income from bonds is merely a portion of that portfolio.
Direct Purchase Income Investing
The most basic income investing strategy is to buy treasury bonds or municipal bonds and hold them until maturity. This simplistic approach is used extensively by novice investors who usually only hold a few different bonds and some only hold one bond. It is fairly common for these investors to have little to no real knowledge of either the bond market or the stock market. The amount invested is typically only a small amount – maybe a few thousand dollars, rather than a few hundred thousand dollars.
When the bond matures they will typically either buy another bond to replace the one that matured or they will use the principle to buy their home or finance their kids’ college education.
There is nothing wrong with this approach and it is simple enough for investors without bond market education to buy treasury bonds and municipal bonds. With the long-term bonds, inflation risk starts to become a problem and they may be better off with the shorter term bonds if inflation continues to increase.
Income Investing with Bond funds
An alternative to Direct Purchase Income Investing is to buy a bond fund. While bond funds do charge fees, these are very low with passive managed bond funds and these funds would basically suit the passive income investor. The investor can choose from a mutual fund, a closed-end fund or an exchange traded fund.
Bond funds make it easy for investors
to hold a bond portfolio
The main advantage of using a bond fund is that they hold a large range of bond maturities which helps reduce the long-term inflation risk.
The investor still receives the relevant coupon payments from the bonds held by the fund, but the return of the full principle is not assured if the investor exits the fund as there might be some capital losses. Generally over the long-term the increased coupon payments tend to outweigh any capital losses. Any capital gains/losses are only relevant to the income investor when they exit the fund, however there may be some capital gains taxes while the fund is being held.
The following tables list some of the many mutual bond funds available.
Table 1. below shows a selection of U.S. Treasury bond mutual funds with various holding periods (data based on May 19, 2017).
Table 1. U.S. Treasury Bond Mutual Funds
The above mutual funds are no-load funds. They all have a minimum initial investment requirement (but there’s no minimum for ongoing contributions).
Table 2. below shows a selection of U.S. Treasury bond mutual funds with various holding periods (data based on May 19, 2017).
Table 2. U.S. Corporate Bond Mutual Funds
The above mutual funds are no-load funds. They all have a minimum initial investment requirement (but there’s no minimum for ongoing contributions).
Laddered Income Investing Tactics
Rather than buying a single bond or several bonds with the same maturity, laddering is a tactic where several maturities are included in a bond portfolio. The main reason for laddering is to help reduce the effect of interest rate changes over the life of the bond. With laddering, the bonds are replaced with the longer term current interest rate bond whenever a bond matures – the bonds are not sold before maturity.
An example of a simple ladder is buying treasury bonds with maturities of say two, five and ten years. The basic idea is to keep buying the longer term bond (which is this example is ten years) after any of the bonds mature. So when the two year bond matures, it is replaced by a ten year bond. The reason that a ten year is used rather than another two year bond is that in two years time the five year bond has three years remaining and the ten year has eight years remaining. Thus in two year’s time the maturities will be ten, three and eight years which is close to the original setup.
The basis for laddering is that if interest rates rise, then the reinvested principle is at a higher interest rate. Should interest rates fall, then the portfolio is still earning higher interest rates from the existing bonds that have not yet matured.
Laddered portfolios can be constructed with any number of maturities. As bonds keep maturing into the future, the maturity setup tends vary somewhat from the initial setup (as with the example with an initial setup of two, five and ten years). The effect of this varying maturity setup reduces as the number of maturities used is increased. For example, laddering with five maturities of two, three, five, seven and ten years will more closely maintain the initial setup as these bonds mature.
The disadvantage with laddering is that it requires more time to manage a portfolio and it also requires more bonds to be purchased which can be a problem for investors with limited capital. Bond funds are a popular alternative for many retail investors as they typically utilize laddering tactics and the minimum capital required is very low with ETF bond funds.
The following tables list some of the many ETF bond funds available.
Table 3. below shows a selection of U.S. Treasury bond ETFs with various holding periods (data based on May 19, 2017).
Table 3. U.S. Treasury Bond ETFs
Treasury bond ETFs provide the investor with a bond portfolio containing a range of maturities. Keep in mind that when buying ETFs the investor buys shares just like when buying stocks (there’s no fractional shares, only whole shares).
Table 4. below shows a selection of U.S. Corporate bond ETFs with various holding periods (data based on May 19, 2017).
Table 4. U.S. Corporate Bond ETFs
Corporate bond ETFs provide the investor with a diversified portfolio of bonds. Keep in mind that when buying ETFs the investor buys shares just like when buying stocks (there’s no fractional shares, only whole shares).
Dollar Cost Averaging Tactics
The popular strategy of dollar cost averaging can be applied to any bond strategy. The only problem being that the dollar amount to be regularly invested is for most investors considerably less than the minimum face value of most bonds (which is $1,000). An easy solution is to buy shares in a bond fund.
Fortunately treasury bonds have a $100 minimum and this may be low enough for investors to utilize a variation to the laddering tactic discussed above.
The purpose of laddering is to reduce the effect of interest rates increasing after the bonds are bought. When an investor incorporates a dollar cost averaging tactic, the potential interest rate increase problem can be managed by simply buying the same bond maturity at regular intervals.
For example, an investor plans to add $400 per year to their bond portfolio using a buy and hold approach. This allows the investor to buy $100 of say a 30 year treasury bond every 3 months. When adding the same bond maturity to the portfolio at regular intervals, the interest rates are averaged out over time. If interest rates rise then the investor is buying the current higher rates and if interest rates drop then the investor still has some higher interest rate bonds in their portfolio.
Over the long-term, the investor ends up holding some low interest rate bonds and some high interest rate bonds.