Consider bonds for fixed income, diversification
Key takeaways:
- Bonds have a coupon rate, which is the interest an issuer pays you for loaning them money.
- Bonds have a maturity date, at which time the principal is returned and collecting interest payments stop.
Investing in bonds may seem boring and not sexy like buying individual stocks, but bonds help provide diversification and stability to one’s portfolio.
Further, bonds can serve as a means of steady cash flow as you collect interest payments and reinvest your principal when a bond matures. When you buy a bond, you are essentially giving the issuer a loan. That issuer can be a corporation, a municipality, the U.S. government, government-affiliated agencies, and foreign corporations and governments. Municipal bonds are exempt from federal tax and can be exempt from state tax if issued by your state. It is important to understand a bond’s investment grade, coupon rate, yield and duration.
Investment grade
Each bond is given an investment grade, from AAA to D, to represent the creditworthiness of the bond and issuer. AAA bonds are most creditworthy, but as is often the case, there is an inverse relationship between risk and reward. The most reliable bonds often have the lowest returns. But, given that lower-grade issuers are more likely to default on their bonds and not return your principal, it makes sense to be conservative with your bond choices and save your risk-taking for Las Vegas.
Coupon rate and yield
Bonds have a coupon rate, which is the interest an issuer pays you for loaning them money. Do not confuse the coupon rate and the yield. Because the value of the bond fluctuates with rising and falling interest rates, the yield also fluctuates. When market interest rates increase after a bond is issued, the price of the bond decreases, and new buyers get a better yield. Conversely, when interest rates fall, theprice of the bond increases, while its yield decreases.
Duration
Bonds have a maturity date, at which time the principal is returned to you and you stop collecting interest payments. We often think of bonds as short-, intermediate- and long-term, with returns commensurate to bond duration.
One can access bonds either by purchasing a bond fund [or exchange-traded fund (ETF)], or by owning individual bonds. There are pros and cons of each approach.
A bond fund is similar to a stock mutual fund in that these large funds are diversified and either managed actively or passively. Bond funds allow a lower minimum investment than individual bonds, easier liquidity and institutional pricing. The biggest disadvantage of bond funds is the net asset value (NAV) of bond funds fluctuate based on interest rates. If one buys a bond fund as interest rates are increasing, the value of their principal falls.
Bond ladders
Individual bonds are often held in bond ladders, where individual bonds of different durations mature at different times (hence the ladder). If the bond is held to maturity and if the issuer does not default, then the principal is returned to the investor. The coupon paid to the investor serves as fixed-income cash flow, unless the investor chooses to reinvest dividends. Typically, once a bond matures, the principal is reinvested until the investor needs more money than the cash flow afforded by the coupon payments, at which time he or she can choose to let the ladder run out and slowly liquidate.
Bond ladders can be constructed by an individual, if he or she has enough time to research and purchase individual bonds. Or it can be professionally constructed and managed. The advantages of bond ladders include return of principal if held to maturity, regardless of interest rate fluctuation. Disadvantages include reduced liquidity, missing out on institutional investor pricing, and the need to have some wherewithal about bonds if you wish to manage a ladder yourself.
For more information:
Chirag P. Shah, MD, MPH, is a soccer and Nordic ski coach, who also practices medicine and teaches in Boston. He can be reached at cshah@post.harvard.edu.
Jayanth Sridhar, MD, is an award-winning podcaster, physician and educator who is chief of ophthalmology at Olive View Medical Center in Los Angeles. He can be reached at jsridhar119@gmail.com.
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