Source: sxc.hu Photo: Logan-5

Source: sxc.hu Photo: Logan-5

Right now, with the volatility seen in the stock market, many are wondering if there are safer places to put their money. As a result, interest in bonds is increasing. Bonds or fixed income investments can add a degree of security and safety to your investment portfolio while providing you with modest, inflation-beating growth.

What are bonds?

First of all, it is important to understand the nature of bonds. A bond is a loan that you make to someone else. You lend money to some entity (usually the government or a company). In return, these entities pay you back — with interest (as opposed to dividends you get on stock investments. Interest and dividends can be treated differently for taxation). Bonds provide governments and corporations with the immediate cash flow they need to keep operations running smoothly. They promise to pay you later in return for the capital they need right now. Because bonds are considered relatively safe — the institutions are thought to be “good for it” — they offer a lower return than riskier investments like stocks and commodities. However, even though bonds are “safer”, it is still possible to lose money on them. You can usually purchase bonds with various durations ranging from six months to 30 years.

One of the key ideas to remember when investing in bonds is that the price of the bond is inversely related to its yield. Simply stated, a riskier bond will sell for less and will offer higher yield to entice investors. Its price and yield will also be volatile as it reflects the investor sentiment in the markets. Conversely, a very safe and solid bond will have lower yield and higher, more stable price.

The most common varieties of bonds are:

  1. U.S. Treasury bonds: These are bonds issued by the federal government through the U.S. Treasury. These are considered the safest bonds out there, since they are backed by the most reliable taxpayer base in the world: U.S. citizens. Treasury Direct is one of the best places to purchase U.S. Treasury bonds.
  2. Corporate bonds: Companies often issue bonds in order to meet their capital needs. Until the recently, many corporate bonds were considered almost as safe as federal government bonds. There are still solid companies with good bond offerings. You can usually purchase corporate bonds through a broker. When deciding to purchase a corporate bond, it is important to consider how the bonds are rated by the rating agencies. Ratings vary from AAA (Ultra-safe) to Junk bonds (also called high yield bonds) and as you can imagine, junk bonds offer the potential for biggest returns but also carry the most risk.
  3. Municipal bonds: State and local governments also issues bonds to help fund various public works and other projects. These bonds are considered risky (even more so in the current economic turmoil when many state and local governments are flirting with insolvency), and they often provide higher returns than other types of bonds. You will have to go through a dealer registered with the Municipal Securities Rulemaking Board. Many municipal bonds also offer tax advantages. Consult with a professional to see whether these are worth the advantages.

Bond funds

Like many other investments, it is possible to put money into funds containing a number of different bonds. Bond funds can result in higher returns than individual bonds as many fund managers spice up the returns using lower grade bonds, but you may sacrifice security. Bond funds do not offer a fixed rate of return, nor do they offer the guaranty of the return of your principal. It is vital that you understand the quality of bonds the funds invests in before you invest in bond funds. Bond funds can be advantageous to those interested in municipal bonds, but who have a smaller amount to invest. Bond funds can also simplify the process of investing in corporate bonds.

Investing in diversified portfolio of individual bonds can become very expensive due to lot size requirements and broker commissions and this is where bond funds are attractive. They can offer a diversified portfolio of bonds with low minimum investment requirements.

Government mortgage bonds are also available. These typically offer higher returns — and higher risk.  A GMNA fund offered by a number of brokerages (including T. Rowe Price, Fidelity and Vanguard) provides interesting opportunities, if you can stomach the volatility and deal with the fact that you may not get as high returns if someone defaults or pays off the loan early.

Bond ETFs are also available, and can provide you with higher returns and lower expenses.

Using bonds in your investment portfolio

Bonds are ideal for adding a degree of stability and security to your investment portfolio, especially if you choose U.S. Treasury bonds. The yield is usually enough to beat inflation (especially if you choose TIPS — Treasury Inflation-Protected Securities), although it won’t blow you away. Devoting too much of your portfolio to bonds, though, can stunt its growth and make it more difficult to meet your retirement or other investment goals. (The 10-5-3 rule can help you figure out the asset allocation you need to meet your goals.) Most experts recommend that you limit your investment portfolio to 20% bonds. Those will a higher risk tolerance can reduce that number to 10% or less.

Bonds can make a valuable addition to any investment portfolio, as long as you understand that they are there to add diversification and underlying stability, and that you should not expect dramatic returns from them.