Bonds are a type of fixed-income investment that typically provides periodic payments according to a set schedule. Though they generally pay lower amounts than what you might expect from long-term equity (stock) investing, they are widely considered an integral part of any investment portfolio.
Why Invest in Bonds?
Bonds offer a level of stability trailing closely behind cash instruments commonly offered by banks, such as certificates of deposit (CDs), money market accounts, and savings accounts, but they tend to have slightly higher returns. Unlike CDs, they trade on the open market.
During financial crises when the stock markets take hits, they also provide a predictable income stream that helps to smooths out those bumps. They have even outperformed stocks during market downturns.
Are Bonds a Safe Investment?
The principal paid to purchase a bond is guaranteed to be returned along with interest unless a company defaults.
By investing in many bond companies, which can easily be done with a mutual fund or ETF, you would likely barely feel the hit, if at all.
However, bonds are not FDIC insured, which becomes an issue when a company defaults.
That said, bonds vary greatly in terms of risk. Bonds from the U.S. government, Treasury bonds, are essentially risk-free, but junk bonds are somewhat precarious.
How Much of Your Portfolio Should Be in Bonds?
You should invest according to your time frame (age) and your risk tolerance. If you’re closer to retirement, you should have a larger portion of your portfolio in safer, less volatile investments such as cash and bonds, given you won’t have as much time to recover from a market downturn.
There are a few common rules of thumb for choosing your bond allocation, or the proportion of your portfolio (collection of investments) composed of bonds (individual or through bond mutual funds and exchange-traded funds). Among these is subtracting your age from 100, 110 or 120 and using the difference as your portfolio’s percentage of stock allocation (for instance, 110 – 25 [my age] = 85, so I would have 85% in stocks and the rest in bonds. In his book Common Sense on Mutual Funds, Vanguard founder John Bogle states his rule of thumb for choosing the allocation ratio of stocks to bonds is to set the percentage of bonds to equal one’s age.
Personally, given their lower historical returns and that I have decades to go before retirement, I wouldn’t want more than roughly 10% of my portfolio in bonds.
Types of Bonds
1. Government Bonds
“Treasury securities” are debt obligations issued by the U.S. government, technically all bonds though only one has “bond” in its name. They are very low risk, guaranteed by the “full faith and credit” of the U.S. government. Interest earned from Treasuries is exempt from state income tax but not federal tax. Here are the types of Treasury securities:
- “Treasury bills” mature anywhere from a few days to one year. They are sold at a discount from their face value (for less than the amount of principal that will be returned at maturity).
- “Treasury notes” can have a maturity of two, three, five, seven, or 10 years, and they pay interest every six months.
- “Treasury bonds” mature in 30 years.
- “Treasury inflation-protected securities (TIPS)” have a built-in mechanism to protect against changes in inflation: Their principal increases along with rising inflation but decreases with deflation, as measured by the Consumer Price Index. Upon their maturity, you would be paid the greater of the adjusted or original principal. They pay interest every 6 months (like Treasury notes), which is applied to the adjusted principal (meaning interest payments vary with inflation and deflation as well).
“Municipal bonds” are both federal- and state-income-tax free (in their state of issuance). They are issued by local governments, often to provide capital for the construction of infrastructure such as highways, roads, schools, and so forth.
2. Corporate Bonds
“Corporate bonds” are issued by corporations. They are fully taxable at the federal and state levels and thus should be invested in from within retirement accounts if you’re in a high tax bracket. The issuing corporation’s repayment abilities provide the basis from which to gauge risk, though their physical assets are sometimes used as collateral.
“Convertible bonds” are a subset of corporate bonds that are “hybrid,” meaning they can convert to a preset number of stock shares in the issuing corporation at a predetermined point in time. If the underlying stock rises in value, profit can be made; the bonds’ taxable interest yield is lower than that of nonconvertible bonds.
Corporate bonds are classified according to their issuer’s overall credit quality and likelihood to default, as determined by credit rating agencies such as Standard & Poor’s, Moody’s Investors Service, and Fitch. Here are the three main classes:
- “High grade” or “high credit quality” bonds have a rating of AAA or AA.
- “Investment grade” or “general quality” bonds have a rating of A or BBB, indicating a low rate of credit default.
“Junk bonds,” also called “high-yield bonds,” “non-investment grade bonds,” or “speculative grade bonds,” have a rating of BB or lower, indicating the highest risk of issuer default (perhaps a couple percent in this group default each year) among corporate bonds. Their higher yields help to compensate for the increased risk.
3. Mortgage-Backed Securities
“Mortgage bonds” are secured by one or multiple mortgages; in the case of default, mortgage bondholders would have a claim to the underlying property. Like Treasuries, they are backed by the full faith and credit of the government; their principal is typically guaranteed to be repaid by the Government National Mortgage Association (GNMA, also referred to as Ginnie Mae) or the Federal National Mortgage Association (FNMA, also referred to as Fannie Mae).
How Bonds Work – Terminology
The “face value,” “par value,” and “nominal value” of a bond all refer to its price when it was first issued—in other words, the bond’s principal that will be repaid upon its maturity date, assuming the bond issuer doesn’t default. It’s called “face value” because it’s the amount shown on the face (front) of the bond certificate. While the bond’s price fluctuates inversely with interest rates after it’s issued, its face value remains the same, as does its interest rate. A bond’s face value is useful as a benchmark; when the bond’s current (market) price is lower than its face value, it’s “selling at a discount,” or if its current price is higher than its face value, it’s “selling at a premium.”
The “coupon rate,” “nominal rate,” or “nominal yield” of a bond refers the annualized amount of interest it pays, expressed as a percentage of its face value. It doesn’t vary with the market price.
For instance, with a bond with a face value of $1,000 and a coupon rate of 5%, you would receive coupon payments of $50 (bond coupon payments are typically made semiannually, twice per year).
Not all bonds pay a coupon; “zero-coupon bonds” are sold at an initial discount, that is, for an amount lower than their face value.
“Bond yield” is a bond’s coupon rate relative to its current market price. There are several types of bond yield to distinguish between:
1. “Current yield” is the bond’s annual earnings divided by its current market price.
2. “Yield to maturity” is an estimation of the bond’s total return if held until maturity. You’ll be guaranteed to receive the principal/face value along with interest if you hold a bond until its maturity, but you also have the option of selling your bond on the open market.
3. “Effective yield” is the bond’s yield if all coupon payments are reinvested; in the case of a bond that compounds, it’s a more accurate measure of return since it takes compounding into account. However, conventional individually purchased bonds don’t allow for compounding; this feature is unique to a select few types of bonds, such as zero-coupon bonds and series I and EE savings bonds. In that scenario, rather than the coupon value being paid to the investor, it is added to the principal, from which future coupon payments are calculated. When investing through a bond fund (in which case you would hold portions of many different bonds), however, you’ll likely have the option to reinvest bond interest—in that case, fund managers use your interest to purchase additional bonds, producing a similar outcome.
Lastly, “duration” is a key measure of the sensitivity of bond prices to interest rate changes (in the general financial environment) that considers a bond’s length of time to maturity and the difference between its coupon rate and yield to maturity. The higher its duration, the higher its risk and price volatility, and vice versa.
Historical Performance of Bonds
Between 1926 to 2015 and based on data from several bond indexes, bonds returned an average annual return of 5.4% before inflation, per Vanguard. Inflation averaged about 2.96% between those years, making the real return (adjusted for inflation) about 2.44% (note that’s before taxes and investment fees).
Predicting Bond Performance
It’s nearly impossible to make an accurate prediction of bond returns in less than a year. If interest rates skyrocket, the resale value of bonds plummets due to the inverse relationship between interest rates and bond prices.
If you’re planning to hold bonds for over a year, however, their current yield (referred to as entry yield in the following quote) is a good indicator of their returns, according to Vanguard founder John Bogle, who said that since 1926 “the entry yield on the 10-year Treasury explains 92% of the annualized return an investor would have earned over the subsequent decade had he or she held the bond to maturity and reinvested the coupon payments at prevailing rates.”