Making Money with Bonds

It is funny how some investors think that all bonds are good for is income and a relative degree of safety, when it comes to investing.  I hope that 2009 was an example, even though an extreme one, that bonds can be more than conservative investment.

Bond is a debt instrument.  To put it simply, an investor loans money to the bond issuer.  Investor traditionally expects to earn a certain amount of interest on that loan, along with eventual repayment of the principal.

Bonds to some extent have certain similar characteristics of other asset classes.  For example, if issuers rating (usually based on current and future business/economic activity of that entity) of an entity is higher than its peers, it is likely to be more stable investment with lower income payments.  If the rating is lower, the bond can provide higher income as well as some capital appreciation, but of course there will be more risk involved.  Corporate bonds traditionally pay higher income than government bonds and are considered more risky.  Longer term bonds tend to pay higher amount of income.  Bonds can offer a certain degree of diversification, because issuers come from different industries and countries.  There are other characteristics that an investor ought to know about bonds before making an investment decision.

So, what are some of the bond investment strategies that an investor may consider?

General: 1) Strategy to generate income – to supplement other income and/or to enhance overall performance of the portfolio.  2) Strategy to diversify the overall portfolio – bonds traditionally tend to have lower correlation to other asset classes, such as stocks.

Specific: 1) Capital appreciation – discount bonds; 2) Yield diversification – laddered portfolio.  This is a strategy where an investor buys a few bonds with different maturities.  This helps an investor manage the interest rate risk and at the same time opportunity to either lock in or get in at very attractive yield levels.  3) Investment with a minimum return guarantee.  As an example, let’s assume an investor has a 10 year investment horizon and investor needs his initial investment ($10K) back at the end of the period.  One way is to buy $6K worth of Zero coupon bonds (discount bonds), which at maturity will provide the $10K requirement and the other $4K can go towards investment in the more speculative areas, where there might be an opportunity to achieve a higher than normal rate of return.  If the $4K investment goes bust, you still get $10K in ten years from those Zero coupon bonds.  If the $4K investment stayed the same, you made $4K and if it grew…well, sky is the limit there I guess.  Bonds can also provide a way to play a certain company’s future prospects, a certain sector or a country prospects and so on.  The benefit there would be the income that an investor would be generating while waiting for the investment to potentially appreciate.

As always, stay diversified.