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How To Invest With Bonds

Lesson 3 - Bonds: The Ballast

Lesson 3 - Bonds: The Ballast

I was once listening to J.L. Collins, a noteworthy investor and author, give his thoughts on investing and he described bonds as being similar to a ballast on a ship and I thought it was a great visual. Ballast is weight added to the bottom of a ship to give it stability and help avoid tipping over in turbulent water. Bonds can be used as a similar mechanism for our investment portfolio as they have historically been more stable than stocks. 

What is a bond?

Bonds are debt taken out by entities such as the government to help fund their operations. Guess what time it is? Analogy time! When you need money to fund a project of your own, how would you do it? Likely you would go to the bank and take out a loan with a predetermined interest rate and for a set duration of time. Bonds are exactly the same except in reverse. The seller specifies the interest and duration of the debt and the buyer in turn receives periodic payments (usually quarterly or 4 times a year) at the interest rate, called the coupon rate (note: there are bonds that don't pay out interest know as zero coupon bonds but they are outside our scope here. Just know they exist). When the duration of the bond is up, the bondholder receives the original specified amount back called the par value.

Now there are risks with bonds. Here are some of them:

  • One is default risk. It happens when the seller is not able to pay you back at the end of the duration of the bond. Typically the bonds that have a higher likelihood of default will pay you more interest. Good ol' "high risk, high reward." 
  • The second is interest rate risk. There is an inverse relationship between bond prices and interest rates meaning if interest rates go up, the prices of bonds go down and vice versa. Example: Say you have a bond with a par value of $1,000 and a coupon rate of 4%. A year later interest rates have risen and the current bonds are now paying 5%. If you wanted to sell your bond, why would anyone buy it for $1,000 if they could buy the same type of bond now and it would pay them 5% instead of 4%? They likely wouldn't so you would have to discount your bond in order to make it attractive to potential buyers. 
  • Inflation Risk is when inflation increases at a higher rate that what the bond is paying. This would happen if you had a bond paying 4% but inflation is 6% on the year so you technically had a -2% return. 

There are other types of risk but honestly they are more complicated and the I think you get the point on the fact that bonds are far from a guarantee.

There are several different types of bonds but I don't think there is much value is going over all of them. The two main types are government bonds and corporate bonds. Government bonds are typically more safe than corporate bonds but also usually pay lower interest. 

So how do we know which bonds are safer than the others?  Lucky for us there are agencies who's job is to research bonds and give them a rating to measure the ability of the seller to repay the debt. The two main ones are Moody's and Standard and Poor (if you're familiar with the S&P 500, it stands for the Standard and Poor 500). They each use a similar but different grading system on bonds. Just remember that bonds with their top four grades are considered investment grade bonds whereas anything below that are junk bonds. Most people stick with investment grade but junk bonds can pay higher interest (high risk... yeah, you get it). 

The last important piece I feel the need to elaborate on would be taxes on bonds. Keep in mind that any interest you receive from a bond is considered income and will be taxed as such by the government. For this reason, bonds are typically best kept in tax advantaged accounts to utilize the advantages given by these compared to a brokerage account (more on these later). The only exception can be certain types of government bonds, such as municipal bonds, that can be tax-free at the city, state, and/or federal level. Be sure to check on the rules for these before purchasing them.

We will now proceed into the next stage of our investment journey by touching briefing on other types of investments that may be beneficial to our portfolio.