In 2019, CISI Capital Markets and Corporate Finance estimated that US stock markets were worth $30 trillion and US bond markets were worth $40 trillion.
More than half of all money invested in Wall Street investments is invested in bonds.
Yet many individual investors don’t understand bonds and how they work, and worse, have no idea how to invest in bonds.
In this column, I hope to answer some of the questions my clients frequently ask me about bonds, bond funds and other fixed income products.
First of all, what is a bond? It is a debt security issued by a government or private entity to raise funds for a specific purpose. Most bonds have a denomination (usually $1,000), coupon (interest rate), credit rating and maturity date.
When purchasing a bond, the bond buyer makes a loan to the bond issuer and the issuer is obligated to pay interest on the loan for the full term of the bond.
When the deadline specified on the bond is met, the issuer returns the initial (principal) investment to the bond buyer and the bond buyer retains all interest.
Bonds can be purchased on the primary (new issue) or secondary market. Primary bond purchases are at par ($1,000 per bond) while secondary market bonds can be purchased at par, at a discount (less than $1,000 per bond) or at a premium (more than $1,000 per bond). obligation).
The credit quality of a bond is rated by one or more of the following agencies; Moody’s, Standard & Poor’s and Fitch. Corporate bonds are categorized as investment grade or high yield depending on the underlying creditworthiness of the bond.
How you buy a bond can be as important as the bond you buy.
Bond laddering is a long-standing method of buying bonds that reduces interest rate risk and diversification risk while providing a more predictable stream of income over time.
Here is an example of a bond buyer who wants to invest $100,000 in the bond market in five different bonds.
The bond buyer looks at interest rates and notices that he can get the best interest rate for a minimum of six years, or 2028. This is just an example, so the actual conditions will be different.
The bond buyer buys 20 bonds that mature in 2028. He then buys 20 seven-year bonds, 20 eight-year bonds, 20 five-year bonds and 20 four-year bonds.
The result is a bond ladder with 20% of the principal investment maturing in 2026, 20% maturing in 2027, 20% maturing in 2028, 20% maturing in 2029 and 20% maturing in 2030.
Bonds pay interest accrued in the money market account.
Almost any bond can be purchased as a bundle of bonds (bond funds, exchange-traded funds) or as individual bonds. There are pros and cons to both, and the investor should be well aware of the difference.
The pros and cons of buying an individual bond are:
- If you buy individual bonds and hold them to maturity, you’re guaranteed to get your principal back, unless the underlying company goes bankrupt. Although fluctuating interest rates affect the value of bonds (up or down), you will receive all of your principal when the bond matures. Individual bonds can be actively managed in the account by the buyer.
- If you sell your bond before maturity, you are subject to market conditions and you could potentially incur a capital loss. Individual bonds have no management fees and the commission for buying the bonds is withdrawn and held for the seller before the bond yields are displayed. There will be a charge for selling a bond before its maturity date. There are no commissions for buying or selling bonds if purchased in a fee-based account. The risk of bankruptcy is higher for individual bonds than for a bond fund.
The pros and cons of buying bonds in a bond fund are:
- Bond funds (mutual funds) hold many bonds and this diversification greatly reduces the risk of bankruptcy.
- Bond funds are more liquid than individual bonds and can be easily sold if cash is needed. Bond funds employ professional managers who have experience and understanding of the bond market.
Most bond funds charge a commission and have active annual management fees. You cannot actively manage the bonds purchased in the fund and you are never assured of the return of your capital with a bond fund since a bond fund does not have a maturity date.
In a rising interest rate environment, bond funds may be subject to significant principal erosion.
There are many types of bonds issued by many types of entities.
The federal government most often issues treasury securities in the form of treasury bonds (maturity between 20 and 30 years), treasury bills (maturity between two and 10 years) and treasury bills (maturity between four weeks and a year).
Zero-coupon bonds are bonds that you buy below par and pay you back when the bond matures after holding them for a specified period of time. US savings bonds are a form of zero coupon bonds.
Municipal bonds are issued by local, municipal or state governments for day-to-day operations as well as for specific projects.
The two main types of municipal bonds are revenue bonds and tax-backed bonds. Most of them are tax-exempt and very attractive to people who live in high-tax states. Some of these obligations can be insured against default of principal.
Corporate bonds are issued by private sector companies. Corporate bonds are generally considered a little riskier than US government bonds, so they usually have higher interest rates to compensate for this additional risk.
If you want to invest in the bond markets, my suggestion is to seek the services of a financial professional with experience in this area. Ask the tough questions to determine if this person has the knowledge, experience and compatibility to guide you through the challenging world of bond investing.
Marc Spinner is a financial advisor at Waypoint Financial Services in Kennewick.