Many investors prefer to invest in bonds because a properly managed bond portfolio can be a great way to establish a relatively safe and dependable income stream. When an investor buys a bond they buy the bond issuers promise to repay the face value of the bond upon the bonds maturity. The bond issuers legal obligation pay the face value of the bond when it matures is the reason that bond investing is less volatile than stock investing. While bond investing is less risky than stock investing it mimics stock investing in one aspect. Investors that want to get higher returns must take greater risk. When an investor decides to build a bond portfolio, they must first ask themselves what type of bond investor, do they want to be. There are four basic categories of bond investors, passive investors, quasi passive investors, semi active investors and dedicated active investors.
Passive Bond Investors
Passive bond investors which could also be called buy and hold investors are generally interested in building a safe and predictable income flow. Buy and hold investors generally buy non-callable bonds like government bonds, municipal bonds or investment grade corporate bonds. These types of bonds are considered safe and do not have the risk or unpredictability of bonds that have embedded options. Buy and hold investors make no assumptions about changing interest rates and generally buy individual bonds, which they hold until maturity. The income from these bonds can be used for general expenses or reinvested into other bonds. The bonds may be purchased at a discount or a premium with the assumption that the full par value will be received when the bond matures. Investors have a choice of purchasing coupon bonds or zero coupon bonds. Investors that purchase coupon bonds like U.S. T notes will receive guaranteed interest payments every six months. Investors that purchase zero-coupon bonds like U.S. T-bills buy the bond for less than the bonds par value, and the difference between the purchase price and the par value is what constitutes their profit.
Quasi Passive Bond Investors
Quasi passive investors generally engage in index investing. Index investors do not actively buy and sell bonds and are to some extent buy and hold investors. The difference between quasi passive investors and passive investors is that quasi passive investors put together a bond portfolio which is structured to mimic a published bond portfolio. When investing in a bond index fund investor’s should consider three factors. How risky is the fund, how high are the funds fees, and what is the funds bottom line. When considering a fund’s risk one should know if the fund invests in high yield bonds with low credit ratings or safe lower yield U.S. Treasury bonds. An investor must also study the funds fee structure as high fees can greatly reduce an investor’s return. Finally, investors need to research a funds long term investment record.
Related: Bonds vs Bond Funds
Semi Active Bond Investors
Semi active investors use what is called the immunization bond strategy. This is a strategy that is often used by institutional investors. The goal of the immunization bond strategy is to provide a predetermined return for a specific period of time regardless of any outside influences. The most common method of immunization is to invest in zero-coupon bonds and then match the maturity date of the bond to a future date when cash will be needed. Since the bonds maturity date and par value are predetermined this method of bond investing is the least volatile. It should be noted that those who use the immunization strategy are best served by investing in low risk government bonds or investment grade corporate bonds. I believe that this is an excellent investing strategy for retirees, because it provides a reliable cash flow, and eliminates market risk and event risk.
Active Bond Investors
The goal of active investors is to maximize returns. As in all forms of investing those who try to maximize their returns must accept higher levels of risk. The active investment style is best used by experienced investors. Active investors are willing to invest in less than investment grade bonds and use strategies such as interest rate anticipation, timing, valuation, spread exploitation, and multiple interest rate scenarios. Active investors are risk takers that are willing to make bets on the future rather than accept the lower returns of passive investors.
While all investment strategies have some risk, a bond portfolio can be structured to provide a relatively low level of investment risk. For instance, short term government bonds are almost risk free. Conversely investors that want higher rates of returns, have the option of investing in the more risky high yield corporate bonds. Effective investors must first determine their investment goals, and their level of risk tolerance. Once an investor has determined their investment goals and the type of bond investor that they want to be, they can buy bonds through either an online discount broker or a full service broker. U.S. bonds can be purchased directly from the government through TreasuryDirect at http://www.treasurydirect.gov.
Darnell Brown is an accountant with over 20 years of auditing experience. He has worked in both the private sector and for the United States Government. He currently works as a freelance writer and has written numerous financial articles for the investmentunderground.com website.