Have you ever loaned money to a friend or family member with the expectation of being repaid with interest? If so, you’re going to be somewhat familiar with how the bond market works already (regardless of whether your friend or family member actually paid you back). Bonds are debt securities that function quite in the same way your student loans or mortgage does. Although bonds are known to be safer investments than stocks, they do carry risks that investors should be cognizant of. When used properly, investing in bonds can be income producers with limited downside. When used improperly, bonds can be a drag on your portfolio.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
Companies have two main avenues for raising capital: debt and equity. Debt is just a business-speak way of saying a loan, which is really all a bond is. Companies (and governments) borrow money from investors by selling bonds, which entitles the investor to a fixed interest rate plus the return of principal once the bond reaches maturity, or the end of it’s term.
Bond prices aren’t set in stone. They may not be as volatile as stocks, but bond prices still rise and fall based on a number of factors. If a company issues a five year bond with a 3% yield a year after selling similarly dated bonds with a 2% yield, the price of the 2% bonds will plummet since a higher yielding bond is now available. Some bonds are inherently more risky than others due to the issuing entity. For example, a bond sold by a small cap startup carries considerably more risk than Treasury bills sold by the federal government. Small caps default all the time; the US government does not.
But risk comes with reward. The current rate (or yield) on 10-year treasury bills is a paltry 1.24%. You’re basically guaranteed to get your principal back with a treasury bill, so the interest payments you receive aren’t as generous. Interest payments from bonds are called coupons and are usually issued biannually, although this can vary. Once the bond reaches maturity, the principal is returned.
Bonds are loans that entitle the investor to periodic coupon payments and a return of principal when the term ends, but that’s all they offer. When you buy shares of stock, you get equity in the company – a claim of ownership that might garner voting rights or dividends based on the company’s profits. Stock prices are more volatile than bond prices and the dividends issued by stocks fluctuate far more than the interest rate of a bond.
Bonds can be traded on the secondary market like stocks on exchanges. While bond prices might be more stable than stock prices, there’s still money to be made trading bonds. The bond market is estimated to have a total size of $119 trillion compared to “just” $46 trillion in the stock market.
Bonds have many different risks facing them, but the three most commonly discussed ones are following:
- Inflation Risk. If inflation rises, bond prices are negatively affected since they pay a fixed rate of interest. Shorter duration bonds are less susceptible to inflation risk than longer duration bonds since inflation has less time to eat into their value.
- Interest Rate Risk. When interest rates rise, bond prices tend to fall. We say tend because this doesn’t occur with 100% accuracy, but it makes logistical sense for interest rate hikes to hurt the price of bonds. When rates rise, companies can offer newer bonds with a higher coupon rate than previously issued bonds. With a better rate available, the older bonds are less attractive and must be sold at a lower price.
- Default Risk. Inflation and interest rates are always interlinked, but default risk is unique to each specific bond. Bondholders are higher on the totem pole than shareholders in the event of a liquidation, but there’s still a risk of losing principal depending on the stability of the issuer. The safest bonds are issued by the federal government, followed by large corporations and municipal bonds. High-yield corporate bonds (or junk bonds) offer the highest coupon rates but also the most risk of default.
Bond returns have lagged over the last few decades and many investors have begun rethinking the traditional 60/40 stock-to-bond portfolio. But the bond market is large and diverse and fixed income securities still have a place in many, many portfolios. Retirees living on fixed incomes depend on the security and stability of investment-grade bonds. High-yield bonds are issued by both small companies and foreign governments who lack strong financial systems. Investing in bonds requires the same due diligence that an investment in stocks or real estate entails. Always be sure to understand the risk each individual bond faces and compare that to the potential reward before buying it.
Work With an Experienced Financial Advisor
We hope you better investing in bonds, and when you are ready to make a financial investment, come to us for financial advice. The goal of personal finance isn’t to amass large sums of money—it’s about getting more mileage out of the money we earn. If you’d like to learn more or need assistance creating a financial plan that suits your needs, contact the team at Good Life of Mount Pleasant today.
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Stock investing involves risk, including loss of principal.
Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.