Every investment portfolio should consider allocating a percentage of funds to bonds at some point over an investor's lifetime. This is because bonds provide stable and relatively safe cash flows (income), which is vital for an investor who is in the asset drawdown or capital preservation stage of their investment planning, and for investors nearing that stage. In its simplest terms, if you depend on income from your investments to pay the bills and your daily living expenses (or will in the near future), you should be investing in bonds.
In this article we'll discuss several different types of bonds, and identify how each might be used to meet an investor's objectives.
- A well-diversified portfolio should include investments in bonds, but the bond market can be complex and overwhelming if taken as a whole.
- Depending on your investment goals, tax exposure, risk tolerance, and time horizon, different types of bonds will be most appropriate for you.
- Knowing the risks and features of each type of bond can help you understand when and how much of that asset class to add to your portfolio.
Building Your Portfolio for Income
Unlike an investment in stocks, a portfolio of bonds can be structured to meet an investor's exact income needs because with stocks, the investor might be dependent on uncertain and unpredictable capital gains to pay the bills. Additionally, if an investor is liquidating stocks for current income, they might have to do so at precisely the wrong time — when the volatile stock market is down.
A well-structured bond portfolio doesn't have this problem. Income can be derived from coupon payments, or a combination of coupon payments and the return of principal at a bond's maturity. Any income that is not needed at a bond's maturity is strategically reinvested in another bond for future needs — this way income requirements are met, while the maximum amount of capital is preserved. The bottom line is that bonds provide a historically less volatile, less risky, and more predictable source of income than stocks.
There are U.S. Treasury bonds, corporate bonds, mortgage bonds, high-yield bonds, municipal bonds, foreign bonds, and emerging market bonds — just to name a few. Each type comes in different maturities (from short-term to long-term). Let's take a closer look at a number of these different bond types.
U.S. Treasury Bonds
U.S. Treasury bonds are considered one of the safest, if not the safest, investments in the world. For all intents and purposes, they are considered to be risk-free. (Note: They are free of credit risk, but not interest rate risk.)
U.S. Treasury bonds are frequently used as a benchmark for other bond prices or yields. Any bond's price is best understood by also looking at its yield. As a measure of relative value, the yields of most bonds are quoted as a yield spread to a comparable U.S. Treasury bond.
Example: Yield Spreads
The spread on a certain corporate bond might be 200 basis points above the current 10-year Treasury. This means the corporate bond is yielding two percent more than the current 10-year Treasury. Therefore, if we assume that this corporate bond is non-callable (meaning the principal cannot be bought out early) and has the same maturity date as the Treasury bond, we can interpret the extra two percent in yield to be a measure of credit risk. This measure of credit risk, or spread, will change according to company specific and market conditions.
If you're wiling to give up some yield in exchange for a risk-free portfolio, you can use Treasury bonds to structure a portfolio with coupon payments and maturities that match your income needs. The key is to minimize your reinvestment risk by matching those coupon payments and maturities as closely as possible to your income needs. You can even buy U.S. Treasuries directly from the U.S. Treasury Department at the same prices (yields) as large financial firms at Treasury Direct.
While not all publicly traded companies raise money through issuing bonds, there are corporate bonds from thousands of different issuers available. Corporate bonds have credit risk, and therefore must be analyzed based on the company's business prospects and cash flow. Business prospects and cash flow are different — a company might have a bright future, but might not have the current cash flow to meet its debt obligations. Credit rating agencies such as Moody's and Standard & Poor's provide ratings on corporate bonds to help an investor assess the issuer's ability to make timely interest and principal payments.
Yield provides a useful measure of relative value between corporate bonds and with respect to U.S. Treasuries. When comparing two or more corporate bonds based on yield, it is important to recognize the importance of maturity.
Example: Bond Yield and Credit Risk
A five-year corporate bond with a yield of seven percent might not have the same credit risk as a 10-year corporate bond with the same yield of seven percent. If the five-year U.S. Treasury is yielding four percent, and the 10-year U.S. Treasury is yielding six percent, we might conclude that the 10-year corporate bond has less credit risk because it is trading at a "tighter" spread to its Treasury benchmark. In general, the longer the maturity of a bond, the higher the yield that is required by investors.
The bottom line is, don't try to make relative value comparisons based on yields between bonds with different maturities without recognizing those differences. And, watch out for and recognize any call features (or other option features) that corporate bonds might have, as they will also affect the yield.
Diversification is key to minimizing risk while maximizing return in a stock portfolio, and it's equally important in a corporate bond portfolio. Corporate bonds can be purchased through a retail broker with the minimum face value generally worth $1,000 (but it can often be higher).
Mortgage Bonds are similar to corporate bonds in that they carry some credit risk, and therefore trade at a yield spread to U.S. Treasuries. Mortgage bonds also have prepayment and extension risk. These types of interest rate risks are associated with the probability that the underlying borrowers will refinance their mortgages as prevailing interest rates change. In other words, mortgage bonds have an embedded call option that can be exercised by the borrower at any time. The valuation of this call option greatly affects the yields of mortgage-based securities. This must be well understood by any investor making relative value comparisons between mortgage bonds and/or other types of bonds.
There are three general types of mortgage bonds: Ginnie Mae, agency bonds, and private label bonds.
- Ginnie Mae bonds are backed by the full faith and credit of the U.S. government — the loans backing Ginnie Mae bonds are guaranteed by the Federal Housing Administration (FHA), Veterans Affairs, or other federal housing agencies.
- Agency mortgage bonds are those issued by the home financing government sponsored enterprises (GSEs): Fannie Mae, Freddie Mac and the Federal Home Loan Banks. While these bonds don't carry the full faith and credit of the U.S. government, they are guaranteed by the GSE's, and the market generally believes that these firms have an implicit guarantee of backing by the federal government.
- Private label bonds are issued by financial institutions such as large mortgage originators or Wall Street firms.
Ginnie Mae bonds carry no credit risk (similar to U.S. Treasuries), agency mortgage bonds carry some credit risk and private label mortgage bonds can carry a great deal of credit risk.
Mortgage bonds can be an important part of a diversified bond portfolio, but the investor must understand their unique risks. Credit rating agencies can provide guidance in assessing credit risks, but beware — the rating agencies sometimes get it wrong. Mortgage bonds can be bought and sold through a retail broker.
High-Yield Bonds, Muni Bonds and Other Bonds
In addition to the Treasury, corporate and mortgage bonds described above, there are many other bonds that can be used strategically in a well-diversified, income-generating portfolio. Analyzing the yield of these bonds relative to U.S. Treasuries and relative to comparable bonds of the same type and maturity is key to understanding their risks.
Just as with price movements in stocks, bond yields are not consistent from one sector to another. For example, the yields of high-yield bonds versus emerging market bonds might change as political risks in developing countries change. You can effectively use yield comparisons between bonds and sectors to make a relative value analysis only when you understand where those differences in yields come from. Make sure you understand how the maturity of a bond affects its yield — this includes embedded call options or prepayment options which can change the maturity.
The Bottom Line
Bonds have a place in every long-term investment strategy. Don't let your life's savings vanish in stock market volatility. If you depend on your investments for income or will in the near future, you should be invested in bonds. When investing in bonds, make relative value comparisons based on yield, but make sure you understand how a bond's maturity and features affect its yield. Most importantly, study and understand relevant benchmark rates like the 10-year Treasury to put each potential investment into its proper perspective.