Asset class: Bonds

What are bonds?
Bonds are interest-bearing loans to the bond issuers (governmental or corporate entities) that mature on a stated future date. Depending on the time to maturity, bonds are classified as short-term bonds (maturity within 3 years), intermediate-term bonds (maturity in 3-10 year), and long-term bonds (maturity longer than 10 years). Corporate bonds are further categorized into investment grade (lower risk, lower yield) bonds and junk (higher risk, higher yield) bonds. Bonds may offer higher interest rate than cash and cash equivalents, but they can still lose purchasing power to inflation (unless indexed against inflation).

Bonds may be traded or held until maturity. In open market trading, the volatility of bond prices tend to be lower than the volatility of stock prices. The prices of bonds are affected by the prevailing interest rate. When interest rates rise, bond prices fall - 5% bonds are less attractive investments when 6% interest is available, so investors want to pay less for those bonds and, in doing so, achieve the same effective yield as 6%. When interest rates fall, bond prices rise - 5% bonds are more attractive than the 4% interest available, so investors are willing to pay more for those bonds.

Do bonds have lower risk vs stocks?
Bonds are erroneously thought to be lower risk investment vehicles than stocks because (1) open market bond prices have lower volatility than stock prices and (2) bonds are "senior" to stocks, meaning bond obligations must be fulfilled before stock investors can receive any money. The safety of capital does not come from the lower volatility or the seniority of the investment vehicle, but from the ability of the issuer's assets and future earning power to meet its obligations. When companies go bankrupt, both bond and stock holders suffer loss of capital. Even companies that seem too large and too smart can fail and go bankrupt - think Bear Sterns, Enron, Arther Anderson, Worldcom/MCI, Global Crossing, HIH Insurance, LTCM (Long-Term Capital Management), Polaroid, Pan Am, and Penn Central.

Bonds vs stocks
Financially strong corporations that can safely meet bond obligations should also generate returns for equity investors, but bond returns are low and limited, whereas stock returns are potentially unlimited. On the other hand, bonds from financially weak corporations may be just as risky as their stocks, but stock returns for companies that turn around their operations are likely to be far higher than junk bond returns. The risk-reward trade off, for me, favor investment in stocks instead of bonds.

Government bonds
Debts issued by governmental entities generally have lower risks than corporate bonds. Sovereign government bonds are called "government bonds" and are considered risk-less because governments can raise taxes and print money as needed (though not without flow-on effects). "Municipal bonds", on the other hand, are bonds issued by non-sovereign governments (state, county, and city governments) to finance local infrastructures, such as road, bridges, tunnels, waterworks, schools. While municipal bonds are low risk, there are rare instances where local governments default on their bond obligations.

US government bonds are available for purchase from US Treasury Direct, or through local banks and brokers, in the form of Treasury bills, Treasury notes, Treasury bonds, Treasury Inflation-Protected Securities (TIPS), Series EE bonds, and Series I bonds.

Investing in bonds
Generally, I do not recommend investing in corporate bonds because of the risks and limited returns. If you want low risk investments, I recommend investing in government bonds, which are truly risk-free.

If you wish to invest in corporate bonds, I suggest investing through broad market bonds index funds. I do not recommend investing in individual corporate bond issues - you will probably be better off buying a company's common stock than buying the company's bonds. You should only invest in individual bond issues if you know how to value bonds and can find individual issues selling at very attractive prices.

I recommend saving long-term emergency reserve (up to 5 years worth of living expenses) in government bonds, such as Series I US Savings Bonds (I Bonds) or Treasury Inflation Protected Securities (TIPS). Generally, 5 years of living expenses should last you through most broad market cycles. You may consider having the entire "bond" portion of your portfolio invested in risk-free government bonds.

Related posts:

• Asset class: Cash and cash equivalents.
• Introduction to index investing.
• The principles of value investing.

P.S. This post was featured in Money Hacks Carnival #13 — Money Saving Hacks Edition at Moolanomy.