Bonds sit in a strange place in our collective consciousness. They’re the “safe” part of our investment portfolios, but they also conjure up images of Wall Street brokers with a brick sized cell phone back in the 80s. Thankfully, we don’t need to consult with Gordon Gecko about our portfolios anymore.
But it is worth taking a step back and looking at what bonds actually are, and how they actually work. Bonds are a crucial part of most everyone’s retirement investment portfolio – and for good reason. But before we get to how you can use them in your portfolio, let’s break them down.
What are Bonds?
Bonds sit in a strange place in our collective consciousness. They’re the “safe” part of our investment portfolios, but they also conjure up images of Wall Street brokers with a brick sized cell phone back in the 80s. Thankfully, we don’t need to consult with Gordon Gecko about our portfolios anymore.
But it is worth taking a step back and looking at what bonds actually are, and how they actually work. Bonds are a crucial part of most everyone’s retirement investment portfolio – and for good reason. But before we get to how you can use them in your portfolio, let’s break them down.
How Bonds Work
But let’s dig in on the actual mechanics of a bond. There are a couple of key components to every bond:
- Face Value: This is the amount that the issuer is borrowing. Or put differently, the principal amount that the bond issuer needs to pay back at the end of bond’s life (we’ll get there in a second.)
- Coupons: These are the interest payments that the bond issuer pays to the bond holders. The coupon rate is the annual interest rate that the issuer pays to bondholders, typically making two equal payments per year. For example, if you hold a $1,000 bond with a 5% coupon rate, you will receive $50 in interest payments per year (5% of $1,000).
- Maturity Date: Bonds have a specific maturity date, which is the point in time when the issuer must repay the bond’s face value to the bondholder. This can range from tomorrow to several decades out into the future.
- Bond Price: The market price of a bond can fluctuate based on various factors, including changes in interest rates and the issuer’s creditworthiness. Bond prices can be above or below their face value.
Who Issues Bonds?
Bonds can be issued by all sorts of organizations – from individual companies (called corporate bonds), to local governments (called municipal bonds), to the national government (they’re called Treasury bonds if it’s the US government issuing the bonds), and all sorts of other organizations as well.
There are two big ways that people classify different bond issuers.
The first way is by how the issuing organization’s (otherwise known as the issuer’s) bonds are taxed. There are effectively three groups here (with a decent amount of complexity when you get into the details).
- Fully Taxable Bonds: These are bonds that don’t have any special tax treatment. All of the money that they produce is fully taxable (providing they are not held in one of your tax advantaged accounts like a 401(k) or IRA. Typically these will be corporate bonds or bonds from an Agency of the US government (but not the US Treasury – told you there is some complexity when you get into the details).
- US Treasury Bonds: US Treasury bonds are taxed at the federal level, but are exempt from state and local taxes.
- Municipal Bonds: This where things get really complicated. Typically Municipal Bonds are not taxed at the federal level, and may also avoid taxes at the state and local levels. They may also have tax implications for people who are subject to the federal Alternative Minimum Tax. Thankfully, most people don’t need to worry about these bonds.
The other big way that people classify bonds is by how likely the issuer is to miss a payment – what is referred to as defaulting on the bond.
Generally, people regard US Treasury bonds as the gold standard. Most investors consider the US Treasury as the issuer least likely to default on their bonds. And then the issuers move down from here.
One thing you may be familiar with is bond ratings (AAA, AA, etc.) These ratings are given out by based on how likely the one of the rating agencies thinks an issuer is to default, not necessarily whether the bond is a good investment.
All else being equal (which it almost never is), an issuer with a lower rating (meaning there is more risk they will default) will need to pay investors a higher interest rate to issue the bond.
The Different Types of Bonds
Most bond operate like we have discussed – the issuer makes two coupon payments per year, and then pays off the face value at the bond’s maturity date. However, this isn’t necessarily true for all bonds.
The two most common un-common bonds are Treasury Inflation Protected Securities (TIPS) and Zero-Coupon Bonds.
TIPS are, well, Treasury bonds that have an added level of inflation protection. Every six months the face value of TIPS adjust based on inflation. In effect, TIPS pay out an inflation adjusted interest rate. This can be a very powerful tool for managing inflation risk within your retirement plan.
Zero-Coupon bonds are bonds that don’t pay any coupons (no one has ever accused bond folks of being creative with their names). Because these bonds do not make periodic payments, they are very sensitive to changes in interest rates, and can be very volatile – especially when their maturity dates are far out into the future. Just like TIPS, these can be very handy in a retirement plan, as they can target future cash flows very precisely. If you know that you will need to pay $10,000 for something at a specific point in the future, you can buy a zero-coupon bond that will pay out $10,000 prior to that date to “immunize” the payment.
Using Bonds in Your Retirement Plan
Bonds are a crucial part of most people’s retirement plan. They are (or at least tend to be) reasonably stable investments that pay out predictable amounts of income at predictable points in time. There are two primary ways that bonds can be used in your retirement plan. The first way is in your investment portfolio, and the second way is to generate reliable income.
Bonds in Your Investment Portfolio
Bonds can be a great tool to include in your investment portfolio. Because they have lower returns, but also lower levels of volatility than stocks, you can think of them as the ballast of the portfolio. The ratio of stocks to bonds in your portfolio is how you set the amount of risk (and corresponding return) you want in your investment portfolio, so getting this right is critical. In fact, I think the ratio of stocks to bonds in your portfolio is the most important decision you’ll make about your investment portfolio.
However, you can also target specific risk factors within your bonds as well. The two most important bond risk factors are Maturity Risk and Credit Risk.
Maturity Risk is the risk that comes from loaning your money out over longer periods of time. Essentially the further out a bond’s maturity date is, the riskier it is.
Credit Risk is the risk that a bond issuer will default.
Just like all systematic risk factors higher levels of risk correspond with higher levels of expected return. Though it’s important that just because a return is expected doesn’t mean it will materialize, especially in the short term (and the short term is a lot longer than most people think).
Most people who use bonds in their investment portfolio will do so by owning them through mutual funds and ETFs rather than owning individual bonds directly.
Bonds as Reliable Income
On the other hand, people who are looking to generate reliable income with their bonds are generally going to use a technique called bond laddering. This is where you own a series of bonds (usually individually, rather than in a fund) so that you will receive a specific amount of income each year (or in whatever configuration makes sense in their plan). Because of this, people focusing on generating reliable income from their bonds are usually very concerned about the possibility of default. If one of the bonds in their bond ladder defaults, they’ll be out a big portion of their future income, so they will tend to use US Treasury bonds (or TIPS if they would like their bond ladder to account for inflation) as the risk of default is usually considered to be lower than other types of bonds.
Probably the biggest difference between holding bonds as part of your investment portfolio and for reliable income comes down to your attitude about the bonds.
When a bond is part of your investment portfolio you are very focused on the value of the bond – you are not planning to hold it to maturity, so you care about the price you can sell it to another investor.
However, with the bonds you are using for reliable income, you generally are planning on holding them to maturity. You are counting on not just the coupon payments, but the big principle payment at maturity, so you aren’t as focused on how the price of the bond changes in the meantime. You just care that the bond will pay out as planned.
However you plan on using bonds, it’s important to remember that they are just a tool to get you where you want to go. And they can be excellent tools – most people will own bonds either as the ballast in their investment portfolio to target a certain level of risk, or to generate reliable income through a bond ladder.
At the end of the day, bonds are pretty simple. They are just loans. What matters is how they fit into the broader context of your retirement plan – and how they help you move that plan forward.
To find out more about investing in retirement, read our eBook 8 Tips to Becoming a Retirement Income Investor.
