Bonds and Bond Funds

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There are government bonds, corporate bonds and also bond mutual funds.

It is important for you to know that I am not now or have I ever been a fan of bonds or bond funds.  Why?  Because bonds are debt and you are lending your money in exchange for interest on your money.

I much rather own a tiny portion of a company by owning stock mutual funds or ETFs.  Plus, bonds are very boring to me.  For me owning a bond is kind of like watching paint dry.

Stocks, on the other hand have always been interesting to me.

Sure, back in the mid 80s, when I would sell certain types of products where you had a choice of bonds, money market, stocks, etc. I put a small amount of money towards bonds, for diversification.  Back then interest rates were double in the digits.

I would recommend putting most of the money into stock funds.  If I remember correctly, I would only recommend placing ten percent or twenty percent into bond funds.

Never sold a bond mutual fund as a stand alone investment.  At that time I was primarily selling a utility fund.

I also want to tell you that I also placed a small percentage of their money into money market.  I believe that this was usually 10% or 20%.  Which was about the same as bonds.  The rest of the money went into stocks.

At that time you were making double digits in money market and you had no risk.

Looking back after all of these years, I believe that I did the right things for my clients.

If I could magically meet all of these clients today, I believe that if I asked each of them how well the products they purchased from me performed up until now, I believe that if all of them were still alive today and they still had these products, they would say that they were satisfied with what I did for them.

It was not my intention to even talk about bonds or bond investments of any type such as bond mutual funds, but I want to give my blog readers a quick summary of bonds so they know at least a little bit about bonds.

What is a bond?

Basically, a bond is a piece of paper which has the words IOU written on it.  In other words it is debt.  Governments and corporations issue bonds when they want to raise money.  Bonds are normally issued for ten, twenty or thirty years.

The issuer of the bond agrees to pay you back the face value of the bond on a certain date.  They usually will pay you a predetermined amount of interest (yield) on your loan every six months for the life of the bond.

Federal government bonds are considered the safest bonds because they are backed by the full faith and credit of the United States.

Because they are considered safer than corporate and municipal bonds they pay a lower interest rate.

Bonds offer a fixed interest rate for a fixed time period.  For example, a ten year bond may offer a 5% yield.  Think of the word “yield” as interest.  In other words, 5% interest.

The interest paid on a bond is called the coupon rate.

There are corporate and government bonds.  Government bonds are normally considered safer because they have the power of taxes backing up the interest payments.

Bond Ratings

There are three major credit rating agencies for bonds.  Bonds with a rating of BBB by Standard & Poor’s and Fitch bond rating scale or a rating of Baa3 by Moody’s or better are considered “investment-grade.”

The higher rated the bond, the lower the bond yield which means investment-grade bonds will always provide a lower yield than non-investment grade bonds..

Bonds with lower ratings are considered “speculative” and often referred to as “high-yield” or “junk” bonds.

Historically, investment-grade bonds have had a lower default rate compared to non-investment grade bonds.

Callable bonds

Some, but not all, bonds are callable.  That means that the issuer can call back the bond and pay off the investor after a certain date such as five years rather than on the maturity date.

A similar non-callable bond would pay a slightly lower interest rate due to less risk for the investor.

Investors don’t have as much interest in callable bonds due to the uncertain maturity date which forces callable bond issuers to pay a higher rate.

The issuer would call the bond, paying back the investor if interest rates have dropped.

For example, if a callable bond has a coupon of 9% and it is callable after five years, the issuer will call back the bond if interest rates drop down to 5%.

The present coupon rate for new bonds is lower than the 9% coupon rate making it cheaper for the issuer of the bond to borrow money.

However, if the bond has a coupon rate of 9% and if new bonds have a coupon of 10% the issuer would not call back the bond because doing so would be more expensive for the issuer of the bond.

There are different types of government bonds.  Municipal bonds (munis) are issued by a municipality (state or city) to pay for things like roads and bridges.

Cities, states and towns have credit ratings.  A poor credit rating increases the risk you will get your money back when the bond matures.

Municipal bonds have tax advantages and the tax advantage is attractive to certain investors.

Interest rate risk

In addition to credit risk bonds are also affected by interest rates.

Bond prices move inversely to yields

When interest rates are going up the value of bonds are going down.

If interest rates are going down bond values are going up.

Bonds have seniority over stocks.

Corporations and municipalities can default.

Bonds pay a dividend twice a year

However, bond mutual funds usually pay a dividend monthly.

This makes bonds attractive to people who are looking primarily for income.

Bonds offer diversification

Not everyone wants or should be one hundred percent invested in equities.

When you are younger normally you would invest somewhere around seventy to one hundred percent in equities and the remainder in bonds.  For small investors, bond mutual funds would be the way to go.

You may want to also keep some of your money in cash.  Cash is considered safe but keeping money in cash has the disadvantage of going down in value over time due to inflation.

Cash can be used to get into the stock market when there has been a huge drop in the stock market using dollar cost averaging.

Usually, as you grow older you increase your percentage in bonds and reduce your percentage in stocks for increased safety.

When you have a percentage of your investments in stocks and a portion of your investments invested in bonds and some in cash this is called asset allocation.

The amount of risk you are willing to take with your investments will determine your asset allocation percentages.

Playing it too safe by keeping all of your money in cash or bonds may not be a good idea.  Right now interest rates are super low.

With low interest rates your return on bonds is going to be in the single digits.

Rule of 72

Before you decide if investing in fixed interest securities (bonds, bond mutual funds and CDs)  is right for you, use the rule of 72 to determine how long it will take for your money to double.

For example, if you can earn 12% interest on your money, it will take only six years for your money to double.  In other words, 72 divided by 12 equals 6.

High yield means high risk

Not all bonds are investment grade.  Corporations that don’t have a good credit are going to have to pay higher interest on the bonds they sell.

High yield bonds are also called junk bonds.  There is a higher chance of default with these types of bonds.

Be very careful when trying to earn a higher yield (interest) on bonds.  For example, if bonds/bond funds are currently paying somewhere around 3% and you see a bond offering 8%, 9% or possibly an even higher yield, your investment risk is also going to be much higher.

You can buy bond mutual funds, bond ETFs and fixed income investments such as CDs and bonds through Fidelity.

Buy bonds directly through the Federal government to save paying commissions.

I hope you have found my basic explanation of bonds helpful.  There is much more to know about bonds than what you see here.  I tried to explain bonds in very basic terms that everyone should be able to understand.

Please leave a comment below.

Happy investing.

Jim Juris Signature

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