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Bonds: The Misunderstood Investment Vehicle

Bonds. Often times when I say the word people think of those financial gifts given by grandparents (war bonds anyone?). Very few of us recognize bonds as a strategic investment for a modern portfolio.

Hopefully today changes that.

In order for us to effectively use bonds, we need to put aside our misconceptions of bonds and establish a strong understanding of what they are. Today I’m going to walk through what a bond is, the types of bonds, and how bonds can bolster your portfolio.

To begin, what is a bond? The simplest answer is, a bond is a loan. By purchasing a bond you’re “loaning” this money to your government, city, or company, with the promise that they will pay you back in full and hopefully with regular interest payments.

Those war bonds I mentioned earlier were also “loans” (or debt securities) to the government to finance military operations and other expenditures during the war. Governments and other public houses often use bonds as a means of raising funds for large projects (think infrastructure) while companies may issue bonds to avoid having to release more shares if they are looking for new funds.

So that gives us three types of bonds: government, municipal, and corporate. How you go about purchasing these bonds will be affected by your current portfolio and tax bracket.

Diving into the characteristics of bonds, one thing to note is that bonds have a term. You’ll buy a bond for say $50,000, with a term. This means that for the next ten years you will receive back whatever the promised interest rate was (for easy math we’ll say 5%). Then at the end of those ten years, you will receive your principle of $50,000 back. So over that ten-year term, you would earn $25,000 in interest on your $50,000 investment.

It’s important to note that a $50,000 bond doesn’t always sell as such. In some cases, bonds are traded at premiums (your $50,000 bonds purchasing price is $60,000). At other times, depending on the market, they’re traded at discounts ($40,000 for that $50,000).

Regardless of how you buy it, low, high or at asking, you will still only receive the value of the bond back in ten years. So, if you paid a premium, you will lose $10,000, however, you’ll still have made money back on your investment giving you a net gain of $15,000 (if we maintain those simple math numbers from before). So, when you buy a bond at discount, you’re not only making all that interest, but will receive an additional $10,000 when you return.

While when we buy a bond, we want it to stay as such for the whole duration of the bond to ensure maximum return. However, to complicate matters some bonds have what you call a callable feature. This is a clause that gives institutions the option of paying the loan back in less than ten years.

How does this affect you? When it comes time to decide which bonds to invest in, you want to be aware of what that would look like at maturity and the worst-case scenario for the first callable date. If your game plan involves your bonds all reaching maturity and they’re called away from you due to the callable clause, you may find yourself with a pot of money to invest and it may not be the right time for you or the right time in the market.

What about the credit risk of bonds? If you’re buying your bonds from the United States Treasury your credit risk is virtually nil. However, if you buy a bond from a small company there is the possibility they could default on the bond. Even some municipalities have defaulted on bonds (Orange County California for example). When a bond defaults you may not lose all your money but depending on where you are in the pecking order of the bonds when they’re repaid by bankruptcy agents, you may not see the whole return.

Another important risk with bonds is liquidity. Bonds are not as easy to sell as stocks since they aren’t liquid. Finding a buyer may prove difficult, or they may not want to pay you what you think it’s worth.

Finally, with bonds, there is interest rate risk. Bonds are locked in at their interest rate when purchased. What that means for you is that if you’ve got a 15-20 year bond, and you’re locked in at a rate of return for the time horizon, if interest rates move and new bonds become available at a higher return you will take a loss if you attempt to reinvest that money in a new bond. The good thing is as long as you hold onto that bond, you’re going get back your principle.

Bonds come in two forms, taxable or tax-free. It’s important to know your tax bracket when deciding which type of bond makes the most sense for you. For many people, they end up purchasing some of both, but you may want help from your financial advisor to determine the best course of action.

Now that we’ve covered the basics of bonds, you may be asking yourself how and why you should use them. One important thing to keep in mind is that bonds can meet income needs. When you’re retired, receiving that 5% back on your $50,000 bond means you’re earning some cash. That income can help supplement your pension along with your other assets.

Another reason to consider bonds is risk tolerance. Bonds are simply less risky than the stock market. They can help to provide a well-balanced portfolio.

The time horizon of bonds is also critical. Since you have a clearly defined returns date, you know when the money is coming back, and you just might need it then.

Finally, as interest rates creep back up, the interest on bonds follow suit. Therefore, they’re starting to bring in more yearly return than they were five years ago.

Hopefully as you can see, bonds are a lot more than just an archaic method for making money. With a proper plan and strategy, they can bolster your portfolio, provide you with an annual payout, and are another opportunity to invest your money.

If you have any questions or concerns regarding your bonds, be sure to reach out to your financial advisor or call us at Heller Wealth Management.

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Larry Heller, Not Your Average Advisor.

 

A CFP® (Certified Financial Planner) and a former CPA.

Has helped solve complex financial planning for 20+ yrs.

Member of Wealth Management Think Tank.

A financial advisor think tank that meets monthly to discuss investment strategies and planning opportunities.

Larry is approached regularly by the respected journals.

“Journal of Financial Planning”, and “The Wall Street Journal”.