Bonds are one of the investment vehicles used by investors. Simply put, bonds are loans made by investors to the government or a corporation. These ‘loans’ have different maturities and government/corporation should pay investor back the original investment and interest, which could be paid monthly, quarterly, semi-annually or annually. It basically works the same way as a mortgage, only in this case the consumer/investor is the one providing a loan.
As briefly mentioned, bond is an investment vehicle. As with any investment, investor should understand different types, characteristics and risk/reward potential of bonds.
Bond Types:
Government bonds – issued by federal, state or local governments. Traditionally considered the most secure bonds. The security depends on the government rating, government stability and economic activity. At the moment US is one example of the government whose bonds are AAA (for now), the highest safety rating. Traditionally, the higher the rating of the bond the lower interest it pays. Not all government bonds are rated AAA or are considered as safe given their instability, economic problems or history. As an example Russia’s bonds are not AAA partly due to a relatively recent default (1990’s) and they do offer a higher level of interest payments.
Corporate bonds – issued by corporations. There are only few corporations in the world whose bonds are rated AAA and considered the safest. As with government bonds the rating of corporate bonds depends on its management, business activity and future business/profitability prospects.
Ratings – Bonds can be insured and therefore considered to be the safest. One of the bond guarantee companies is MBIA. Investment grade bonds – bonds with the BBB or higher rating by S&P. Though investment grade bonds may not be guaranteed they are traditionally considered to be a safer investment as opposed to High Yield (Junk) bonds. Junk bonds are rated below BBB by S&P and there are rated below investment grade for a reason. They may have business problems, future earnings visibility problems…
Now, after the above quick crash course in bonds, let’s move on to benefits and downside of bonds.
Pros:
Income – great way to compliment your other cash flow. Income provides somewhat of a cushion during turbulent economic times. Or plainly one can live off of income, if enough is generated.
Par value – is the amount that should be returned to investor at the maturity. This provides a way of knowing whether you are paying a premium or a discount for investment.
Diversification – traditionally bonds have had a lower correlation to other asset classes such as equities. Diversification is a great way to protect portfolio from high volatility.
Par value – I wanted to mention this again because not many investments out there can tell you how much you might expect at maturity.
Lower rated bonds – combination of higher income and equity-like performance characteristics may provide superior returns to other asset classes.
Cons:
Lower rated bonds can be volatile
Bonds can still default and investors may lose value
During rising interest rate periods bond prices tend to fall
The top reason to be invested in bonds is the fixed Income component. You always know, unless there is another 2008/2009, how much income you will be receiving from your investments. The income that you receive is hard, cold cash in your pocket. Income is certainty and certainty is something that is hard to come by in the investment world.