Considered the “old reliable” of investment options, bonds may not give the highest returns, but they are a safe and stable investment tool.
Normally issued by the federal government or a company, bonds are a type of loan. You, as the investor, are loaning the bond issuer a sum of money with the promise of being paid back the principal amount plus interest. The interest is usually a fixed rate of return for a certain period.
When an individual bond is purchased, the issuer (either a company or the government) will pay the purchaser interest payments, usually twice a year. On the maturity date, or when the bond matures, the issuer pays back the purchaser the price of the bond. Interest rates change over the lifetime of a bond and can affect the value of them.
There are some strategies that can produce higher yields. Let’s take a closer look.
Bond Ladders
While this may sound like something agent 007 might use to escape from a precarious situation in a James Bond film, bond ladders are a type of portfolio of bonds and other fixed-income securities. Other holdings in a portfolio include certificates of deposit (CDs), treasury bills, and treasury notes.
A bond ladder is made up of assorted bonds of the same dollar amounts that mature on different dates. These maturity dates are dispersed by months or years, staggered by comparable intervals. Bond ladders consist of several “rungs,” and can be anywhere from five to 10 bonds.
What does this look like? If you had $50,000 to invest in a five-year bond ladder, you wouldn’t purchase a five-year bond at $50K. Instead, you would purchase five $10,000 bonds that matured one year apart from each other.
It could look like:
● Bond A: $10,000 at 1% rate, matures in 1 year
● Bond B: $10,000 at 1.5% rate, matures in 2 years
● Bond C: $10,000 at 2% rate, matures in 3 years
● Bond D: $10,000 at 3% rate, matures in 4 years
● Bond E: $10,000 at 3.5% rate, matures in 5 years
As Bond A matures, you can either take the proceeds and use them for something else, or reinvest it by purchasing Bond F to continue the bond ladder.
How does this benefit the investor? All bonds come with some type of risk, including credit, interest rate, and liquidity. Bond ladders help by:
Reducing Credit Risk. Depending on who issues the bonds, the creditworthiness can be a positive or negative influence on your returns. If a company’s creditworthiness is compromised, this can cause their bonds to drop in price. Bonds issued by the federal government are secure and usually not at risk of defaulting.
Reducing Interest Rate Risk. Bond prices decrease when interest rates go up. A bond ladder lowers the risk of interest rate fluctuations because they spread the bonds across differing maturity dates.
Reducing Liquidity Risk. If you had invested all $25K in a five-year bond, your money would be tied up, not liquid, for five years unless you sell it and possibly incur loss. By staggering the maturity dates, you can decide what to do when each bond matures: either keep the proceeds or reinvest.
Bond ladders are a portfolio in which multiple bonds purchased in equal amounts come to maturity on different dates.
Bond Funds
A slightly different strategy to purchase bonds is with a bond fund. These funds are akin to mutual funds and are managed by a manager who buys and sells for all of the investors in the fund. These are a great option for those with smaller portfolios.
Some features of a bond fund include:
● Array of Bonds. These could be corporate, federal, government agencies, or municipal bonds.
● No Minimum Investment. You can get started with any size of investment.
● Monthly Payments. Instead of being paid every six months, you receive income every month. The amount will vary from month to month, depending on what the market is doing and how the fund is being managed.
● Liquidity. You can direct your fund manager to buy and sell bond shares at any time. Rarely are bonds held to maturity with bond funds.
● Fees. Because a portfolio manager manages bond funds, there are sales charges and other fees required.
Bond funds are very much like mutual funds. A portfolio manager oversees the fund and the buying and selling of a variety of bonds for the group of investors.
Which is Best?
Which bond strategy is best for you: bond ladder or bond fund? It depends on your financial situation and your goals.
Some things to keep in mind:
Fixed Amount Payments. A bond ladder pays the same amount at the same six-month mark every time. With a bond fund, the amount may change from month to month.
Return of Principal. The bond purchased as a rung in the bond ladder will pay you back the principal amount for which you purchased it.
Ongoing Fees. Both ladders and funds will have some fees, but a bond fund has ongoing fees that are paid to the fund manager who oversees the bond fund.
Final Thoughts
Bonds help stabilize your overall investment portfolio. While we normally consider them safer than stocks, they do come with certain risks. You can lower those risks with a good bond ladder strategy and certain types of investment-grade bonds.
We’ve covered a lot of information in this article! It’s important to know which bond strategy is best for you and your unique situation. We are happy to answer any of your questions regarding bonds, bond ladders, and bond funds.