The most important tasks of an investment portfolio are protecting one’s capital from inflation, while also growing the investment at the same time. To achieve this, the capital can be invested in stocks, real estate, ETFs, and Bonds. While stocks, real estate, and ETFs offer higher returns for their investors, there is an element to those investments that investors try to avoid at all costs, which is a risk. Portfolio risk is fought with bonds. But what are bonds and how do they differ from stocks? Here’s how.
Essentially, bonds are a loan from the person who purchased the bond. The bond can be issued by a corporation, which is called corporate bonds or it can be issued by a government, called government bonds. Owning a bond does not entitle the holder to a share of the company or government. Each bond comes with its terms and condition, which are subject to the company or government that has issued them.
The conditions can cover the interest rate offered, the length of the bond, and the minimum investment amount. At the end of the term of the bond, you are then given the original amount invested, plus the pre-agreed upon interest. It is important to note that although bonds have a lower risk the stocks, they are not risk-free investments, as the corporation or government issuing the bond does have a chance of bankruptcy. The only bond that is considered to be “risk-free” in finance is the bond that is issued by the United States Government. Just like stocks, it is important to understand the terms of the bond that you will be purchasing, such as the maturity date, yield, and credit rating.
There are 3 main types of bonds that investors can choose from, US Government bonds, municipal bonds, and corporate bonds. Each type of bond has its pros and cons associated with them. US Government bonds, also called T-bills, are the safest form of investment in the world, as they are essentially a loan to the US government and the likelihood of the US government going bankrupt is essentially zero. Due to having the lowest risk, their returns are also some of the lowest.
Municipal bonds are not direct loans to the US government but are issued by municipalities and local governments. Municipal bonds are used to finance public infrastructures, such as roads, schools, and highways. Unlike T-bills, they do have higher risk but are still considered relatively safe investments. The income earned the municipal bonds is also eligible for special tax benefits due to investing in investments that serve the greater good.
The 3rd most common type of bond is corporate bonds, which are issued by corporations. The bonds are used by companies to expand the company and in turn, the company gives you interest payments, which are agreed upon before purchasing the bond. Corporate bonds can be relatively low risk to incredibly high risk, which is entirely dependent on the company and the company’s credit rating.
All corporations are evaluated based on their creditworthiness, from AAA to junk. Strong and established companies in their industries such as Apple, Microsoft, and Ford Motor Company have a higher credit rating due to their position in the market, regarding revenue growth, profit, and debt levels. The better the financial position the company is in, the higher the credit rating. As a result, the higher the credit rating, the safer the investment and the lower the return and vice versa. It is important to note that corporate bonds are not to be confused with shares in a company, despite being with the same company.
Owning shares in a company means you are a partial owner in a company, called equity. A stock just means that you own a minuscule share in a company, the more shares you own in a single company, the more of the company you own. With bonds, you are not purchasing a portion of the company, but you are loaning them capital. Corporate bonds can have less risk than stocks in the same company due to volatility in the market.
When it comes to risk, stocks and ETFs can have the highest amount of risk of any investment. Investors try to balance the amount of risk their portfolio has in relation to the returns, by reducing the amount of risk as much as they can. To achieve this, they will need to diversify their investment. But what is diversification?
Diversification is a strategy when investing that will lower your portfolio’s overall risk, while also making the portfolio less volatile to market swings. To reduce the volatility of a portfolio and increase diversification, investors can invest in bonds. The reason why investors have bonds in their portfolios is to increase the overall diversification and reduce the volatility of their portfolios. Bonds also offer stability to a portfolio as bonds do not move with the overall stock market.
It takes a lifetime of saving and investing to have a portfolio that will sustain an individual during retirement with the income that is generated. There are two main ways to generate income from a portfolio during retirement, which are dividends and interest from bonds. Since dividends are issued by companies through their shares, having bonds in a retirement portfolio is an essential aspect of retirement.
Relying on dividends for income would mean that the entirety of a portfolio is comprised of stocks, which is an incredibly risky decision to make in retirement. Instead, dividend income can be supplemented by interest earned from bonds by investing in several different bonds, such as T-bills, corporate bonds, and municipal bonds. Just like investing in stocks, the bonds in a retirement portfolio would have varying degrees of risk and interest payments.
An important aspect of using bonds is their predictability, especially during times of uncertainty. Retirees cannot afford to have significant investment losses when there is an economic downturn when it comes to their overall portfolio and dividend income. If a retiree relies heavily on income generated solely from dividends, they may find themselves in a less-than-ideal financial situation. To offset dividend incomes, individuals can rely on all forms of bonds for predictability and stability.
Bonds may offer fewer returns than stocks for example, but they are an essential part of any portfolio. The diversification aspect of bonds is one of their main benefits by reducing risk, fewer taxes with municipal bonds, and most importantly, having a predictable income stream without having to rely on corporate shares for dividends. Although the chance of issuer default will always be present unless dealing with T-bills, bonds still offer their investors a safe and reliable investment environment even in the harshest of market conditions.
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