Why invest in bonds?
E*TRADE from Morgan Stanley09/08/20
“They’re intimidating.” “I don’t understand how they work.” “I’d rather stick with what I’m comfortable with.” These sentiments describe how many investors feel about bond investing. Though on the surface bonds seem complex, in reality the fixed income (bond) market is actually a lot simpler than it seems. Understanding how this important asset class works can go a long way towards helping both novice and sophisticated investors diversify their portfolio and take advantage of investment opportunities.
Let’s review and simplify some key components of the fixed income market to help jumpstart your bond investing journey. By demystifying the bond market, you’ll see that it’s really not complicated at all.
How do bonds work? Where can I purchase them?
Bonds are sold by various issuers—namely companies, governments, and municipalities—to raise money to fund ongoing expenses and finance operations. An investor who buys a bond is essentially making a loan to the issuer of the bond. In return, the borrower (issuer) is obligated to adhere to the terms of the loan. These terms may vary, but an investor typically receives fixed interest payments on stated dates and a return of their principal at the end of the loan period, aka when the bond matures.
Investors can purchase bonds on either the primary or secondary market. The original sale of a bond by the issuer (a “new issue”) takes place on the primary market. When you purchase a bond on the primary market, you are the first owner of the bond. New issues are typically purchased at a face value (also known as par value) of $1,000.
You may also purchase bonds on the secondary market by transacting with someone who already owns the bond, such as another investor or securities dealer. If you want to sell your bonds prior to maturity, that would also be done on the secondary market. Depending on price movement, you may incur a gain or loss on the sale of your bonds in the secondary market.
What are the benefits of investing in bonds? What makes them important to a balanced portfolio?
Bonds are incredibly versatile. They can be used to achieve a wide variety of investment objectives.
- Diversification/risk mitigation: You’ve likely heard the benefits of diversification for an investor’s portfolio. Allocating a segment of your holdings to fixed income securities is a common method to diversify and reduce overall portfolio risk. In times of market turmoil, bonds typically experience less price volatility and can help hedge against an equity market downturn.
- Principal preservation: Not every investment needs to be a home run. Sometimes, your goal is to simply reach first base—i.e., not lose your initial investment. If that’s your objective, bonds can be a key component of your strategy. Here’s why: Your bond’s principal (face value) is usually returned on a set maturity date. As a result, risk-averse investors often target higher-quality Treasuries and brokered CDs to protect their capital. It might not have the glamor of a skyrocketing tech stock, but in the market, sometimes slow and steady wins the race.
- Income generation: This is another big reason why investors choose bonds—you can get paid interest. Bonds can reward investors with recurring interest payments for lending their money to an issuer for a stated period of time. Many investors rely on the predictability of interest payments from bonds to supplement their regular income stream. They can be used to help with day-to-day household expenses, or to help meet specific financial goal like tuition payments or a home renovation.
- Tax advantages: Lastly, some fixed income investments such as municipal bonds can offer investors potential tax advantages. If investors purchase municipal bonds from an issuer in their state of residence, the interest income may be exempt from federal, state and local taxes.
What are the most common risks of bond investing?
Although bonds are generally less risky than stocks and other investment choices, they still carry some risks that you should be aware of. We’ll discuss what these risks are and some tips on how to potentially minimize them.
- Credit/default risk: Credit or default risk is the risk that the issuer will be unable to make the bond’s interest or principal payments when they are due. Consider investment grade bonds to minimize credit/default risk. Bonds that are rated higher by a credit rating agency are typically less likely to default.
- Interest rate risk: Rising interest rates pose a risk to bond holders because they may reduce the market value of your bonds. As discussed earlier, interest rates move inversely with bond prices, so as interest rates rise, the price on your existing bond will fall. Creating a bond ladder can help lessen interest rate risk by creating a portfolio of fixed income securities that mature at regular, staggered intervals. You can build a bond ladder online in just three easy steps using our Bond Ladder Builder.
- Call and reinvestment risk: If you buy a callable bond, you run the risk of your bond being called in early by the issuer. This is more prevalent when interest rates are declining. In this case, you will receive your principal payment back prior to the bond’s maturity, generally with a premium slightly above par. It’s important to note that depending on the purchase price of the bond, early calls can result in a loss. When looking for a subsequent bond investment, it might be difficult to find comparable yields at an equivalent credit rating—known as reinvestment risk. To reduce call and reinvestment risk, you may want to consider noncallable bonds.
- Liquidity risk: You may encounter liquidity risk if you are looking to sell your bond prior to maturity. Liquidity risk occurs when there is difficulty selling a bond for the same price you paid for it. Generally, this is more prevalent for certain bonds with thinly traded markets. To reduce exposure to liquidity risk, consider more liquid bonds such as Treasuries or corporates, which feature more active markets.
For most corporate and municipals bonds, E*TRADE from Morgan Stanley customers have a choice of ways to access a bond’s trade history:
By clicking on the bond Issuer Name, you will be redirected to the Bond Offering Detail Page. From there, you can access the Trade History link. Clicking on it will open a pop-up box with the TRACE/MSRB feed.
Various types of bonds, explained
In the bond market, you will often hear terms such as municipals (or “munis”), corporates, or Treasuries (typically T-bills, notes, and bonds). These are all various types of bonds available to purchase. Here we’ll provide a brief overview of the different bond types. You can find a more detailed look at the characteristics of different bonds in our Types of Bonds article.
Corporate bonds are issued by public or private corporations. Corporations issue bonds for a variety of reasons. They can help finance general business expenses, expand operations, or provide a source of funding for acquisitions. Corporate bonds generally carry more risk than government-issued bonds but offer higher yields in return.
Municipal bonds are issued by states, cities, counties, and other local governments to help fund public projects. Municipal bonds are popular amongst bond investors due to their tax advantages. Most municipal bonds are tax-exempt at the federal level, and may offer tax exemptions at state and local levels for residents of the issuing state.
There are two main categories of municipal bonds: general obligation (GO) and revenue bonds. GO bonds are secured by the taxing authority of the issuing state or municipality. Revenue bonds are backed by the income generated by the public project the bond is funding.
Certificates of Deposit (CDs)
Brokered CDs are a unique fixed income instrument which feature a range of structures and offer the safety of FDIC insurance coverage. To learn more about how CDs might benefit your investment portfolio, visit our Understanding Brokered CDs article.
Government bonds include those issued by the US government and other government sponsored agencies, such as:
Treasury bonds are backed by the full faith and credit of the United States government. As a result, they are generally considered to be the safest bond investments. Due to their high credit quality and low risk profile, Treasury bonds typically offer lower yields compared to other investments. Interest income from Treasury bonds are usually exempt from state and local taxes and are only subject to federal taxes. The US Treasury issues new bonds with varying maturities at regularly scheduled auctions. You can view the Treasury Auction Schedule to see when the Treasury is issuing new bonds. Or, you can buy and sell Treasuries on the secondary market on our Bond Resource Center at any time.
The different types of Treasuries include:
- Treasury bills (T-bills) – Short-term maturities ranging from 4–26 weeks
- Treasury notes (T-notes) – Medium-term maturities ranging from 2–10 years
- Treasury bonds (T-bonds) – Long-term maturities of 10 years or greater
Agency bonds are issued by one of two types of entities: federal government agencies, or US government-sponsored enterprises, also known as GSEs , (federally charted, privately owned companies serving a public purpose) to fund public projects. Agency bonds feature very high credit quality and typically higher yields than comparable Treasury bonds. Agency bonds issued by federal agencies are backed by the full faith and credit of the US government, but agency bonds issued by GSEs are not—and as a result they are subject to heightened credit risk. Agency issuers include the Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae).