What are bonds and why should you hold them?

by | Jul 1, 2022 | Financial Planning

When you begin researching ways to structure your portfolio, there are many investment options that you could encounter. One of these options is bonds, but investors are often unsure how these investments work and what benefits they could provide inside their portfolio.

Understanding your investment options can help you make informed decisions regarding your account and better understand the advice you receive from a financial advisor. So, it is important to be able to answer the questions ‘what are bonds?’ and ‘how do bonds function?’.

What are bonds?

You may have seen local campaigns supporting bond referendums to raise money for schools, parks, or other projects within your community. These are referred to as Municipal bonds and are often issued by cities or counties to raise funds for a project without raising taxes over the long term.

You may not be aware that you can buy these types of bonds after they are implemented and earn interest from your investment. Here’s how it works: an entity needs capital, usually to fund a specific project. Rather than taking out a loan from a bank, they issue a bond. The issuer agrees to make fixed interest payments to buyers – referred to as bond holders – for the term of the bond. At the end of the bond term, the principal is returned to the bond holder.

To further illustrate this point, consider the following example:

Your local government needs $2 million to fund the construction of a new school. To raise these funds, they offer 2,000 bonds for $1,000 each at a 3% annual interest rate for the next ten years. They might be structured in such a way that if you purchased one of these bonds, you would receive regular payments equivalent to 3% of the bond’s original value (a.k.a. face value) each year. In addition, you would receive your $1,000 initial investment back at the end of the 10-year period. In this simple example, you would receive $300 per year for ten years, and $1,000 at the end of the 10-year period.

Municipalities are not the only issuers of bonds. Other entities like the federal government and businesses can issue bonds. These are called Treasuries and corporate bonds and they work in a similar way – paying interest for the life of the bond, and then returning the principal at the end of the bond term.

Bond Prices and Yields

One term that you will hear often in reference to bonds is their yield. This is the amount of interest that the bond pays.

The yield that an issuer offers on their bond is determined by many factors, such as the creditworthiness of the issuer, the length of the bond term, and the prevailing market interest rates. Once a bond is issued, the yield is set. So, if you buy a 3% bond, you will receive 3% interest each year of the bond term, no matter what happens in the market.

As you can imagine, over the term of a bond, market interest rates can change drastically, and the creditworthiness of issuer and risk associated with the investment can change as well. While these changes aren’t reflected in a bond’s yield, they can impact its resale value.

If market interest rates rise, and new bonds are issued at higher rates, existing bonds become less valuable on the secondary market. This is one of the key tenants of bond investing: bond prices move counter to bond yields. However, it is important to remember that if you continue to hold your bond, the income you receive does not change based on the market.

Why invest in bonds?

Bonds play an important role in many portfolios. They can provide a steady stream of income that can be especially beneficial for retirees. But they also have other benefits that are less well known.

Bonds Provide Income

As previously stated, bonds provide reliable income that does not change based on market conditions. This can be particularly beneficial for retirees and those who rely on their investment income to fund their living expenses.

Bonds Provide Diversification

Minimizing risk is an important aspect of portfolio construction and diversification is one common method for reducing overall portfolio risk. This strategy includes buying different types of assets with either low correlation or negative correlation. The end results should stabilize your portfolio, because when the value of one of your holdings falls, the others should remain steady or rise – all other factors remaining equal.

For the past 20 years, bond prices have had a negative correlation with stock prices . So, holding bonds can help insulate your portfolio against swings in the stock market.

Some Bonds Provide Tax Benefits

Income from municipal bonds – those issued by cities, counties, and states – is generally exempt from federal taxation. Additionally, income from Treasury bonds – those issued by the federal government – is generally exempt from state and local taxation. While you won’t recognize these tax benefits in a tax deferred retirement account, they can make government bonds an attractive investment option for non-retirement accounts.

Bonds Provide Capital Appreciation

Because bond prices move counter to bond yields, if market interest rates fall during the term of your bond, your investment could become more valuable in the secondary market. So, you could sell your bond for a profit in this scenario. For this reason, bonds can provide capital appreciation in your portfolio.

How to Invest in Bonds

One of the most common methods for investing in bonds is to purchase a bond fund. Bond funds can hold hundreds or even thousands of different bonds. As an investor in one of these funds, you are entitled to a portion of the income and capital appreciation from the underlying holdings in the fund.

As with any investment, it is important to speak to an experienced financial advisor before deciding to invest in bonds. A financial advisor can analyze your current financial position, your goals, and your risk tolerance to determine which investments suit your needs.

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