Individuals and institutions can use bonds in many ways: from the most basic, such as for preserving principal or saving and maximizing income, to more advanced uses, like managing interest-rate risk and diversifying a portfolio. People sometimes perceive bonds as stodgy and old-fashioned and associate them with gifts from their grandmothers.
Tutorial: An Introduction To Bonds
Bonds can also be an afterthought, especially during flight-to-quality events, when investors flock to the safest bonds they can find to weather financial storms. In fact, bonds are much more complex and versatile than they appear to be, and provide a variety of options for investors in any investment environment. Read on for the top six ways that you can put bonds to work for you. (To learn more, read our Bond Basics Tutorial.)
1. Preserving Principal
One of the most common uses of bonds is to preserve principal. While this concept works best with bonds that are perceived to be risk-free, like short-term U.S. government Treasury bills, investors can apply it to other types of bonds as well. Barring any catastrophic events, bonds are effective in preserving principal. Because bonds are essentially loans with scheduled repayments and maturities, lenders (bondholders) can expect their bonds to retain value and terminate at par upon maturity. (This is a simplified version of the life of a bond: there can actually be significant volatility as prevailing interest rates change and affect the value of the bond). A risk-free bond purchased at par and held to maturity should preserve principal, mature at par and provide a dependable cash flow. (For further reading, see Common Mistakes By Fixed-Income Investors.)
Saving for the future has historically been one of the best uses of bonds. Savings bonds, as they are aptly named, provide one of the most secure and time-tested approaches to long-term saving. They are guaranteed by the full faith of the U.S. government and are sold in various formats, including discount and interest-paying formats. Savings bonds are designed to be held to maturity and are typically given as gifts to young investors to help them learn about saving. (To learn more, read The Lowdown On Savings Bonds.)
3. Managing Interest-Rate Risk
Interest-rate risk is the risk inherent in all bonds that the price of the bond will fluctuate with prevailing rates. This risk exists because a bond's priced value is a culmination of the present value of the future interest payments and returned principal upon maturity. Because of this valuation, there is an inverse relationship between the bond's current price and the prevailing rates. For example, when current rates rise, all else being equal, the price of the bond should fall. This is a very simplified example of the relationship between interest rates and bond prices and applies to the highest-quality bonds first. Beyond interest rate changes, other risk factors can affect a bond's value, including credit, liquidity and length to maturity. (Get a deeper understanding of the importance of interest rates and what makes them change in Forces Behind Interest Rates.)
Diversification is often the most overlooked use of bonds. The generally low correlation between bonds and other asset classes makes bonds an excellent diversification tool. For example, one could create a simple portfolio of large-cap stocks and U.S. government bonds where the cross correlation between the assets is usually less than one. While it is rare to finds two assets that are perfectly negatively correlated, the diversification between bonds and stocks cans help to smooth out those volatile market swings, especially during flights to quality. (They may not be sexy, but bonds do have a place in every balanced portfolio. Find out why in Advantages Of Bonds.)
5. Expense Matching/Immunization
Individuals commonly use bonds to match a future expected cash need. Institutions also use this strategy on a more complex basis called immunization. The concept assumes a match of the duration of the bond to the expected cash flow, which can be easily accomplished by using a zero-coupon bond in which the maturity matches the bond's duration. While this will not provide any income over the life of the bond, it will provide a direct match.
6. Long-Term Planning
One of the benefits of bonds over other asset classes is that bonds have a predictable stream of income that can be used to fund future expenses for individuals and corporate pension obligations for institutions. This is one of the reasons financial institutions, like banks and insurance companies, use long-term bonds for their long-term planning. Bonds enable them to match their assets to liabilities (commonly known as asset/liability matching) with a much higher degree of certainty than with other asset classes.
Risks Of Bonds
Of course, none of these strategies will work if the bond's coupon payments or the return of its principal become uncertain. Bonds of all qualities carry inherent risks, such as credit, default and interest-rate risk. The credit and default risk can be mitigated by purchasing only investment-grade or U.S. government securities. It's important to note that even bonds that are considered investment grade can quickly fall below this standard. Interest-rate risk can also be mitigated just by holding the bond to maturity, as the par value will be returned upon maturity. (Don't assume that you can't lose money in the bond market - you can. Find out how in Six Biggest Bond Risks.)
Individuals and institutions can use bonds for long-term planning, preserving principal, saving, maximizing income, managing interest-rate risk and diversifying portfolios. Bonds provide a predictable stream of coupon income and their full par value if held to maturity. Could your dull portfolio use a kick from these "stodgy" investments?