Bonds 101: Investing in Bonds

Investing in Bonds

A bond is a type of fixed income investment. When you buy a bond, you are lending money to another entity. The borrower on the other end of the bond is frequently a municipal, state, or federal government body, or a private entity (like a hospital raising funds to complete a project). The “fixed” of fixed income refers to the schedule and payments - you know ahead of time how much interest you’ll be getting and when. The borrower is promising to pay you back at a set time in the future with interest payments along the way.

Bonds can add diversification to your investment portfolio. Bonds are generally lower risk and lower return than equity (stock) investments and can reduce the volatility of a heavily stock-focused portfolio.

Types of Bonds

There are a few types of bonds you might want to consider:

International Bonds

• What: An international bond is a bond issued by an entity that is not domiciled in the same country as the investor. For example, a U.S. investor may buy a bond issued by a German company in Euros. For the Germany company this is a domestic bond, and for the U.S. investor, it is an international bond. These bonds are usually corporate bonds and are commonly found in U.S. mutual funds.
• Why: Investors benefit from portfolio diversification by adding international bonds to their portfolios. International bonds provide exposure to other countries and their economic conditions. A U.S. investor whose portfolio includes bonds issued in Asian countries will benefit when Asian economies are doing well, even if the U.S. economy is suffering. A portfolio that includes international bonds from a range of countries and regions will be relatively insulated against economic downturns in any particular part of the globe.
• Potential Risks: International bonds are denominated and pay interest in a foreign currency, so their value fluctuates with the economic conditions in the issuer’s country, and with the exchange rates between the investor’s and issuer’s countries. That means that these bonds are subject to currency risk, or exchange-rate risk. Currency risk is the potential for change in the relative price of two currencies in relation to each other. The bonds may also be subject to different regulations and taxation requirements than the investor is used to.

Municipal Bonds

• What: Municipal bonds are financial vehicles for communities to build schools, fix highways, improve water systems, maintain bridges and tunnels, upgrade hospitals, and more. Municipal bonds are a means for investors to loan money that funds local infrastructure and public works programs. In short, when a municipality needs to raise money for an infrastructure project, they often issue bonds. These bonds fund a project over a designated period of time. During that scheduled period of time, investors are paid interest (typically semi-annually) until the bond matures, at which time they receive their initial principal back. There are two types of municipal bonds, a general obligation (GO) bond and a revenue bond. A GO bond is usually backed by a municipality’s local government and carries an unconditional promise of repayment. GO bonds generally pay investors via a general fund or through a dedicated local tax. Revenue bonds fulfill debt obligations via raised money. For example, a bridge that collects a toll or a sporting facility that raises money via ticket sales.
• Why: Municipal bonds tend to help buffer portfolios as the stock market fluctuates. Municipal bonds are unique in that they offer both tax-exempt income and high credit quality. They have particular appeal for income-oriented investors in higher tax brackets who want to reduce federal and state income tax bills. The municipal bond tax exemption makes them attractive enough that investors often choose them over their corporate counterparts.
• Risks: Municipal bonds tend to be less liquid than their corporate counterparts, which investors should consider before investing.

Short-Term Bonds

• What: Short-term bonds have a maturity date of less than five years. Any entity can issue short-term debt, including all levels of government (federal, state, local), as well as corporations. A short-term bond fund is a fund that invests in short-term bonds. A short-term bond fund’s portfolio may include things like variable-rate corporate and real estate debt, taxable municipal bonds, packages of car loans and credit card bills, revolving equity credit lines, and even soon-to-mature junk bonds.
• Why: Short-term bonds are low risk. They tend to have lower interest rate risk than intermediate- or long-term bonds (1). That’s because the shorter maturities normally translate to a lower risk of losing some of your principal. Short-term bonds offer predictable income. The yield of the fund’s portfolio is known on a daily basis and bonds are attractive because of the promise of repayment of your original investment at maturity. Short term bonds also offer a potentially higher yield than money market funds. A portfolio mix with a wide variety of bonds is why short-term bond funds offer higher yields than money market funds. Short-term bond funds can offer a decent yield advantage relative to money market funds—anywhere from 0.5%–2%, depending on their underlying investments—and this can add up over time.
• Risks: Short-term bonds are highly sensitive to expectations for interest rates. If the markets expect the Federal Reserve to raise interest rates in order to combat inflation, then the yields on shorter maturity bonds (such as a 2-year Treasury note) will quickly rise to meet those expectations. The end result is a drop in the share price of the bond fund, although its drop will be less than that for bonds funds holding longer maturity bonds. That provides a better ratio of return for the risk taken.

Short-term government bonds:

• What: U.S. Treasuries come in maturities ranging from one month to 30 years. Short- term Treasuries are called Treasury bills (from one month to one year); intermediate term Treasuries are called Treasury notes (two year, three year, five year, seven year and ten year); longer term Treasuries are called Treasury bonds (30 years). Treasury bills are non-interest-bearing. Instead, they are bought at a discount to face value (par) and investors are paid the face value when the bills mature. Treasury notes and bonds pay interest on a semi-annual basis. The principal is paid back when the note or bond matures. A short-term government bond fund will invest in Treasury bills and/or Treasury notes with a 2-3 year maturity, as well as short-term obligations of federal government agencies.
• Why: U.S. Treasuries come maturities ranging from one month to 30 years. Shorter-term Treasuries are called Treasury bills (from one month to one year); intermediate term Treasuries are called Treasury notes (two year, three year, five year, seven year and ten year); longer term Treasuries are called Treasury bonds (30 years). Treasury bills are non-interest-bearing. Instead, they are bought at a discount to face value (par) and investors are paid the face value when the bills mature. Treasury notes and bonds pay interest on a semi-annual basis. The principal is paid back when the note or bond matures. A short-term government bond fund will invest in Treasury bills and/or Treasury notes with a 2-3 year maturity, as well as short-term obligations of federal government agencies.
• Risks: Just like regular short term bonds, short-term government bonds are also highly sensitive to expectations for interest rates.

Buying Bonds

You can purchase government bonds directly from the US Treasury or you can invest in exchange traded funds (ETF) or mutual funds through your brokerage. Bond funds provide more diversification by holding bonds with different maturity dates, debt ratings and interest payments. Try these searches to get started:

• Invest in bonds
• Invest in municipal bonds
• International bonds
• Short-term Bonds
• Short-term government bonds

References:

1. Chen, James, “Interest Rate Risk Definition and Impact on Bond Prices,” Investopedia, 25 September 2022 https://www.investopedia.com/terms/i/interestraterisk.asp.