Investing in Bonds

Investing in bonds is a popular alternative to investing in the stock market for many new investors. Their perception is that it is easier and safer than the stock market and they are under the general impression that their money is guaranteed. This is not necessarily the case and can cause the beginner investor considerable distress when their bond portfolio underperforms.

Just like there is some background studying that needs to be done to understand the stock market, there likewise is some background studying that needs to be done to understand the bond market.

A bond is simply a financial contract whereby an investor lends money to the federal government, an agency, a municipality or a corporation. The bond has a serial number and contains the terms and conditions of the contract, which includes the amount loaned, the interest payment terms and the date at which the money will be returned.

The terminology for bonds is straight forward and can easily be understood by stock investors. Buying and selling bonds is a simple process and a lot of online stock brokers also provide a bond brokerage service.

Adding bonds to an investment portfolio is a popular strategy by stock investors. The performance of bonds is usually poorly correlated with the performance of the stock market. This means that when the stock market underperforms it is common for bonds to outperform, thus bonds help to reduce the volatility of the returns from a portfolio consisting only of stocks.

Bonds are popular with stock brokerage accounts and with retirement accounts such as IRAs. There are many reasons why stock investors buy bonds and they range from receiving an income payment to investing safely in the short-term. Some stock investors utilize bond investing strategies in the same way as they do with their stock investing. Indeed some investing strategies combine corporate bonds with stocks.

Understanding Bonds - Investing in Bonds; picture of a pen pointing at prices printed in the financial newspaper for investors to select for their portfolio

For stock investors who prefer not invest directly in bonds there are a vast variety of funds which specialize in bonds. There are also mutual funds which are designed specifically for retirement investing which are known as Target Date Retirement Funds which combine stocks and bonds.

The common bond categories stock investors include in their portfolios are Treasury bonds, Municipal bonds and Corporate bonds. While bonds are low risk, there are some risks with bonds that investors should be aware off.

Treasury bonds are virtually guaranteed and in addition to their safety, treasury bonds are not callable, thus a Treasury bondholder will continue to receive their coupon payments until maturity with no risk of early recall. Also treasury bonds have a tendency to appreciate in value during economic recessions as opposed to stocks which typically decline in value during recessions.

While the out-performance of treasury bonds during economic recessions is appealing, in the long-term they underperform stocks by a fair margin. Stocks tend to average around 10% or more over the long-term while treasury bonds tend to average around 5%.

Municipal bonds are popular for their tax advantages, but they are slightly more risky than treasury bonds.

Corporate bonds tend to be more popular with experienced and active investors as they are more risky, but they also provide the higher long-term returns. However the long-term return from corporate bonds is only about one to two percent more than treasury bonds.

Junk bonds provide a couple of percent more return than corporate bonds but these are at a higher risk of default with a lot of volatility and the long-term return is still less than that from stocks.

Bonds come with a variety of returns, risks and volatilities and depending on the investor’s goals can provide more diversification than a stock only portfolio.