Are You Missing The Point Of Bond Investing?

If you take a look at any successful portfolio, you will see a mix of stocks and bonds. While perhaps not as sexy as their equity counterparts, the value and importance of bonds is often overlooked by the rags to riches or in many cases, the riches back to rags story of stocks.

The principle advantage of bonds is that they're rated in their risks. The bond has a term where it pays off (say 10 years) at which point you get your initial investment back. Bonds will pay a steady income of whatever their return rate is, taken as a percentage of the initial investment. Thus, if you invest $100 000 in a series of bonds that return interest at a coupon rate of 3.5%, each year, you'll get $3 500 of interest income. The big advantage of bonds is their steady income stream, and that you get the initial investment back when you're done.

So, what's a sensible investment strategy for bonds? Well, it depends on the type of bond you're buying. Short term (less than five year) bonds tend to have low coupon rates, but have the advantage that your assets aren't tied up for long periods of time. A mix of short term bonds means that if an emergency strikes while you're retired, you're very likely to have a bond maturing to give you an immediate lump sum of cash. Medium term bonds tie your money up for longer stretches of time (typically more five to seven or ten years.), while long term bonds tie your money up for 10 to 30 years or more. The coupon rate will also vary with the credit worthiness of the company the money is lent to; lower credit ratings result in higher coupon rates, and the highest credit rating is typically governmental bonds; this is one reason why the 30 year Treasury bill (or T Bill) is used as a baseline bond metric.

While the coupon rate is the most understand concept in bond investing, its not necessarily where all the money is made. Remember, people buy and sell bonds well before their maturity date. As such, when the interest rate moves lower, the price of an existing bond moves higher, thanks to its higher rate of return than a newer bond would provide. On the flip side, if interest rates move higher, the bond price moves lower, simply because new bonds will now provide a higher rate of return than your existing ones. If you make the call on the direction of interest rates correctly, you'll find yourself in the money by a few percentage points. That can make a huge difference in your portfolio.

Finally, there's the yield of the bond, which is a bit more involved, but simple to calculate. The yield rate is the ratio of the annual return of the coupon rate divided by the current purchase price of the bond. For example, that $100 000 bond with an annual payout of $3 500 has a yield of 3.5% if it's bought at $100 000. If it were purchased at $90 000 (due to an increase in interest rates), it would still return $3 500 per year, and would have a yield of $3 500/$90 000 = 3.8%. Just like the purchase price varies inversely with the interest rate, so does the yield.

Want to improve your stock market returns? Get tips on Vanguard mutual funds overview, penny stock and US Savings Bonds at 1source4stocks.