Investing in Bonds For Dummies
Overview
Improve the strength of your portfolio with this straightforward guide to bond investing
Investing in Bonds For Dummies introduces you to the basics you need to know to get started with bond investing. You’ll find details on understanding bond returns and risks, and recognizing the major factors that influence bond performance. Unlike some investing vehicles, bonds typically pay interest on a regular schedule, so you can use them to provide an income stream while you protect your capital. This easy-to-understand guide will show you how to incorporate bonds into a diversified portfolio and a solid retirement plan.
- Learn the ins and outs of buying and selling bonds and bond funds
- Understand the risks and potential rewards in corporate bonds, government bonds, and beyond
- Diversify your portfolio by using bonds to balance stocks and other investments
- Gain the fundamental information you need to make smart bond investment choices
This Dummies investing guide is great for investors looking for a resource to help them understand, evaluate, and incorporate bonds into their current investment portfolios.
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About The Author
RUSSELL WILD advises clients in retirement planning and global portfolio diversification through the use of fund management. He has written nearly two dozen books on financial topics.
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If you know nothing else about investing, know the following five eternal, essential investment truths — all real-world tested — and you'll be way, way ahead of the game.
Risk and return are two sides of the same coin
If you see an investment that has gained 50 percent in the last year, sure, at least consider taking a position.
One of the hottest debates among investors — one that will never end — is whether actively managed investments are any wiser than index fund investments. The simple answer is usually no, they are not. The vast majority of index investors do better than the vast majority of active investors. Although various studies show various results, none contradicts the basic premise that indexing works, and works very well.
Bonds
One of the few constants in the world of investing is the tendency for investment returns to revert to their mean. What this means is that if a particular kind of investment (stocks, bonds, what-have-you) typically returns X percent a year, but for the past several years has returned considerably more than X, you have a better than 50/50 chance that the returns are in for a slowdown.
At the heart of the fundraising effort in World War II was the creation of war bonds. Even before the United States entered World War II, a massive effort was underway to raise money to build the military and support allies in war-torn Europe and Asia.
In April 1941, with great fanfare, President Franklin D. Roosevelt purchased the very first such bond from Secretary of the Treasury Henry Morgenthau, Jr.
All bonds are traded through brokers. But some bonds available for sale are new or primary issues. Others are secondary issues. Yes, it's something like buying a new versus a used car — except the used bond isn't necessarily any cheaper.
In fact, according to Bill Conger (a principal and senior portfolio manager with Red Hook Management in Morristown, New Jersey), bonds that are just issued, especially in the municipal-bond arena, quite often offer juicier deals.
Bonds
Bonds differ greatly as far as risk, expected return, taxability, sensitivity to various economic conditions, and other factors. Because of this, calculating fixed-income returns is quite difficult.
So you invest in a $1,000 bond that yields 6 percent and matures in 20 years. What do you do with the $30 coupon payments that you receive every six months?
Bonds
The transaction costs incurred when investing in individual bonds, which have traditionally been way higher than stock transaction costs, have been dropping faster than hail.
One 2004 study from the Securities and Exchange Commission found that the average cost of a $5,000 corporate bond trade back then was $84, or 1.
One approach to investing is dollar-cost averaging. Instead of throwing all your money into a bond portfolio right away, some people say it makes more sense to buy in slowly over a long period of time. As the argument goes, you spread out your risk that way, buying when the market is high and when the market is low.
Obviously, you want to look at any prospective bond fund's performance vis a vis its peers. If you are examining index funds, the driving force behind returns will be the fund's operating expenses. Intermediate-term Treasury bond index fund X will generally do better than intermediate-term Treasury bond index fund Y if less of the profits are eaten up by operating expenses.
For most people, some kind of in-between portfolio — perhaps with Ginnie Mae bonds and tech stocks —makes the most sense. Deciding if you want to be smack in the middle of the continuum, or prefer to hang your hat toward the mild side or the wild side, will have a great bearing on just how much you stock up on bonds or bond with stocks.
What's the difference between an annuity and a bond? With an annuity, you don't expect to ever see your principal back. In return for giving up your principal, you expect a higher rate of return.
Returns on annuities grow larger the longer you hold off on buying one. (Extreme example: Any insurance company would be more than happy, I would think, to take your money, stick it into an annuity, and pay you 20 percent a year — provided you are 97 years old.
Bonds
As predictable as the Arizona sunrise, CDs, like zero-coupon bonds, offer your principal back with interest after a specified time frame (usually in increments of three months) for up to five years in the future. Like savings bank accounts, CDs are almost all guaranteed by the Federal Deposit Insurance Corporation (FDIC), a government-sponsored agency, for amounts up to $250,000.
Bonds
The U.S. Federal Reserve has three "magic" powers with which to expand or contract the money supply, or move interest rates. They are open market operations, the discount rate, and reserve requirements:
Open market operations: This term means nothing more than the buying and selling of Treasury and federal agency bonds.
Selling bonds online can be a much trickier business than buying them. You have a particular bond you want to dump, and the market may or may not want it.
At Fidelity, you're best off calling a Fidelity fixed-income trader and asking that trader to give you a handle on what the bond is worth. You can then go online, place a "Limit Price" order to sell, and you'll very likely get what the Fidelity trader told you you'd get.
Bonds
Suppose you've decided that you want a 50/50 portfolio: 50 percent stocks and 50 percent bonds. Suppose, in addition, that you have both a taxable brokerage account and a conventional IRA. You've decided to put all your bonds in the IRA and all your stocks in your taxable brokerage account. Do you really have a 50/50 portfolio?
What does the Rule of 20 have to do with your choice of investments and the wisdom of holding bonds? Simple: The further away you are from achieving that financial goal, the higher the rate of savings you need or the higher the rate of return you require from your portfolio — or both.
People who need a higher rate of return generally don't want too bond-laden a portfolio.
Regardless of which way you decide to invest your money, bond funds or individual bonds, the going is easier and potentially more lucrative today than it was just several years ago. And it's getting easier all the time.
Expensive bond funds still exist. According to Morningstar Principia, at least 180 of them charge 2 percent or more in annual fees.
What makes work-for-pay optional (other than being born rich, resorting to crime, or marrying a heart surgeon) is a freedom portfolio — a portfolio big enough to produce the income needed to support your lifestyle.
When is a portfolio big enough that employment becomes optional? When it provides enough cash flow to pay the bills: both today's and tomorrow's.
All bonds have a CUSIP that identifies the bond in the same way that a license plate identifies a vehicle. CUSIP stands for Committee on Uniform Securities Identification Procedures, which is a part of the American Bankers Association.
Although it's often referred to as a CUSIP number, that is something of a misnomer because a CUSIP typically contains both letters and numbers.
In the United States, people have the minimum required distribution (MRD) on 401(k) plans as well as regular and rollover IRAs. And woe is you if you miscalculate. Your finances will certainly be pummeled hard, but at least you won't be stoned.
You should be happy to live in a country where people who break the law are given due process and, if found guilty of a crime, they'll neither have their limbs removed, nor will they be stoned to death.
Bonds
It you're looking for a bond fund that's going to produce steady returns with little volatility and very limited risk to your principal, start with a bond fund that is built of low-volatility bonds issued by credit-worthy institutions. A perfect example would be a short-term Treasury bond fund. If you're looking for kick-ass returns in a fixed-income fund, start looking for funds built of high-yield fixed-income securities.
Bonds
Added longevity means, all things being equal, is that it behooves you to invest a wee bit more aggressively than did your grandparents. Lifespans have increased. If you are now 65, there's better than a 50/50 chance that either you or your spouse will still be alive at age 90. If you plan to retire at age 65, that means you need a portfolio that can provide cash flow for at least 25 more years.
As far as default risk, agency bonds are almost as safe as Treasury bonds. However, you get a bit of extra kick on the coupon payments. These issues lack the liquidity of Treasury funds, which explains much of the premium. They are also mortgage-backed, which means they are subject to greater volatility (due to prepayment risk) but also offer greater diversification from other bonds, such as corporate bonds.
Rather than picking and choosing, perhaps you'd like to buy up a representative sampling of the total bond market? Then consider these options.
T. Rowe Price Spectrum Income (RPSIX)
Contact: 800-683-5660; T. Rowe Price
Type of fund: Actively managed mutual fund
Types of bonds: Anything and everything in bonds, with a smattering (currently 12 percent) in stocks
Average maturity: 7.
High-yield bonds return more than other bonds, but you can lose your money in times of recession when shakier companies start to default on their loans.
iShares iBoxx $ High Yield Corporate Bond Fund (HYG)
Contact: 800-474-2737; iShares
Type of fund: Exchange-traded fund
Types of bonds: Corporate high yield
Average maturity: 6 years
Expense ratio: 0.
Bonds
U.S. government bonds can be bought on TreasuryDirect without paying a markup. Nonetheless, Treasury bond funds offer instant diversification of maturities at modest cost. Remember that while conventional Treasury bonds are said to carry very little risk of default, they do carry other risks, such as interest-rate risk.
An astonishing number of bond funds charge loads. A load is nothing more than a sales commission, sometimes paid when buying the fund (that's called a front-end load) and sometimes paid when selling (that's called a back-end or deferred load).
NEVER PAY A LOAD. There is absolutely no reason you should ever pay a load of (not unheard of) 5.
The nest egg goals you establish now have everything to do with how heavily you invest in bonds. Where does the multiplier of 20 come from in your investment strategy? It simply gives an approximation of how much you should have by age 65 to cover your yearly expenses, based on the current average lifespan (mid 80s).
A difficult decision for bond investors putting in fresh money occurs at those rare times in history when you see an inverted yield curve. The yield curve refers to the difference between interest rates on long-term versus short-term bonds. Normally, long-term bonds pay higher rates of interest. If the yield curve is inverted, that means the long-term bonds are paying lower rates of interest than shorter-term bonds.
You first choose a bond category: Do you want a Treasury bond, an agency bond, a corporate bond, or a municipal bond? What kind of rating are you looking for? What kind of maturity? What kind of yield?
Most online bond shops walk you through this process step by step; it isn't that hard. The most difficult piece of the process is making sure that after you know what kind of bond you want, you get the best deal on your purchase.
Bonds
So what would you have earned, after taxes, investing in long-term government bonds over the past nine decades or so? Well, compared to stocks, which have returned about 10 percent a year before inflation and 7 percent after inflation, you would have earned squat. With corporate bonds, you'd have earned slightly more than squat.
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