What are Bonds & Should I Invest in Them Instead of Stocks?
Are you new to investing? That’s ok! Now is a great time to get started. As you look to build your portfolio, you’ll see many different investment options. Two of the most common options are stocks and bonds.
Often, new investors aren’t sure how each of these investment vehicles fit into their overall financial plan. Building a solid portfolio involves understanding the different types of investment options available to you and selecting those that are most consistent with your goals and comfort level.
To get a clear picture of how bonds might fit into your portfolio, you must understand them. So, let’s look at exactly what bonds are and if you should invest in them instead of stocks.
What is a Bond?
A bond is “a fixed income instrument that represents a loan made by an investor to a borrower.” This means as an investor in a bond, you’re lending money to the company, government, or entity issuing the bond. They will then pay you back the amount you lent them plus interest after a set period.
Interest rates on bonds used to be fixed, but it’s common now to have bonds with variable or floating interest rates as well. And the date you get paid back for your loan is known as the bond’s maturity date. It’s common to see bonds issued by the government and corporations.
Types of Bonds
There are many different types of bonds you could include in your portfolio as part of your investing strategy. To get you started in understanding and investing in bonds, let’s talk about four of the most common bonds you might see.
US Government Bonds
One of the most common types of bonds is a government bond. In the US, typically, you’ll see government bonds issued by the US Government.
These bonds are typically considered one of the safest investments because they are guaranteed by the US Government. This means no matter the economic situation the US finds itself in, the investors in US Government bonds will be paid back.
While US Bonds are often considered a safe investment, you can buy bonds issued by governments all over the world. It’s important to know that other government bonds carry more risk than US Government bonds.
Just like the US Government issues bonds, local governments also issue bonds to raise funds for different public investments. These bonds are typically used to raise money to develop infrastructure, build schools, and complete other projects for the public good. These bonds are called Municipal bonds and are sometimes referred to as Munis. Munis are typically safe investments. And often, you don’t pay federal income tax on interest earned on Munis.
Corporate bonds are bonds issued by private companies to raise money for operations. There is a wide variety of corporate bonds. This can give some choices to the investor because, typically, the different corporate bonds have different interest rates, maturity dates, and levels of risk. The risk associated with corporate bonds is dependent on the creditworthiness of the company issuing the bond.
Bond ETFs (Exchange-Traded Funds)
Another option is a Bond Exchange-Traded Fund (ETF). Investing in a Bond ETF will allow you to get more exposure to the bond market at a price that’s more accessible for new investors.
A Bond ETF is a fund made up of different types of bonds. Typically, each Bond ETF tracks a specific index of bonds. And the funds are passively managed. Buying a Bond ETF allows you to diversify your bond holdings more without buying a wide variety of individual bonds.
Understanding the Risks of Different Bonds
As you’re comparing different bonds to one another or comparing stocks to bonds, it’s important to understand how to evaluate the risk of bonds.
While bonds are often seen as safer investments than stocks, all bonds carry a degree of risk. This risk is known as “credit risk,” and it refers to the possibility that an issuer may default on the bond payments before the bond reaches maturity.
If this happens, you could partially or completely lose the income you were expecting. You might also lose your principal investment.
If you want to identify and understand the risk associated with a particular bond, there are several independent groups outside the bond market that rate bonds. These ratings are determined based on the rater’s appraisal of the creditworthiness of the company or entity issuing the bond.
Typical ratings range from AAA to D. Bonds with ratings in the AAA’s and BBB’s (Baa if the rating entity is Moody’s) are often considered good investments. These typically come with the label of “investment grade.” Bonds rated below this level may be good additions to some portfolios, but they carry a higher level of risk and possibility of default.
It’s important to understand the risk of the bonds you’re considering investing in. This will help you understand the investment and how it fits into your portfolio.
How Should Bonds be Incorporated into Your Investment Strategy
When it comes to building a portfolio, you want to build one that’s consistent with your accepted level of risk, is diverse, and will help you reach your goals. It isn’t about buying just stocks or buying just bonds. Instead, you want to buy a mix of different investments to help you build a portfolio that’s right for you. Here are a few things to consider as you build your portfolio.
When deciding what to invest in and how much of your portfolio you want allocated to certain investments, it’s important to consider your risk tolerance.
Risk tolerance refers to how much risk you’re willing to accept from your investments. There’s no guarantee of gains with investing. But some investments are riskier than others.
Typically, bonds are seen as less risky than stocks. This is because bonds represent a loan to a company or government entity. They have a maturity date and a face value that the borrower will repay along with interest. Often, they are also less volatile than stocks.
Knowing your risk tolerance can help you have the right combination of stocks and bonds in your portfolio to help your overall risk be at acceptable levels.
Have you ever heard the expression, “don’t put all your eggs in one basket?” This is a good thing to remember when you’re investing too. You don’t want to build a portfolio that is only invested in one or two things.
If the market for that sector falls, your principal will be at risk. This is why you want to diversify your portfolio.
Diversifying your portfolio means investing in a variety of things with different levels of expected risks and returns. It can help you protect your portfolio because as one investment falls, the others will hopefully remain consistent or increase to offset the loss. Having a diversified portfolio helps you weather the ups and downs of the market over time.
One good way to diversify is to have a mix of both stocks and bonds. The two investment types come with different levels of inherent risk. Having both in your portfolio can keep it within your risk tolerance. It can also help you weather the ups and downs of the market.
Know Your Goals
When you’re deciding how much of your portfolio to invest in stocks and bonds, it’s also important to consider your financial goals.
As you start your portfolio, get clear on your goals and why you’re investing money. Then get specific on when you hope to reach your goals.
For goals with a shorter time frame, choosing less risky investments (like bonds) that allow your money to grow but without endangering too much of the principal can be a good choice.
For goals with a longer time horizon, assuming a bit more risk from your investments can work if you’re comfortable with it. This will allow your money to earn more over time. It also gives you a longer time horizon to recuperate after any losses your portfolio experiences.
It is important as you build your portfolio to understand the role both bonds and stocks play in helping you maintain balance. With any investment, do your research and keep your goals at the center of your planning. This will help you build a financial plan that’s right for you.