Bonds can be a great tool if you’re looking to balance your portfolio by diversifying your investments and reducing volatility.
But how do they work? And what kind of bonds are best for your profile?
Many investors get overwhelmed with bond terminology, which drives them away. However, when you understand a few key terms, you’ll see how simple they are and how to make them work for you.
What is a Bond?
A bond is a loan where the investor (that’s you) is typically promised a set interest rate (i.e., the coupon payment) and a return of their investment (i.e., par value) in the future. The coupon rate is typically paid annually or semiannually and usually doesn’t change after the bond is issued. Bonds can be issued by:
- Corporations
- Federal, state, and local governments
- Federally chartered companies
- Various entities such as banks, real estate investment trusts, and mutual companies
Bonds don’t give you ownership rights like stocks, and you may not benefit from the company’s growth. However, this also means you won’t be hit as hard when the company doesn’t perform well—granted, the issuer can still stay current on its loans.
Thanks to this, bonds can potentially benefit you by:
- Offering another income stream
- Balancing the possible volatility of your stocks
Building a Bond Ladder
You might have heard of a bond ladder in your research. So, what is it, and why is it important?
Bonds are generally issued with designated maturity dates (i.e., full repayment date) and may also include various (callable) features that may allow the issuer to retire or “call” the debt prematurely. This may happen if a company finds it can borrow at a lower interest rate.
A bond ladder is a structured portfolio of credit obligations with various maturity dates spread over a predetermined timeline. The interval ladder allows for an anticipated schedule of cash flows, prevents you from “timing” the market, and prepares you to reinvest your bond proceeds and stick out interest rate fluctuations.
Taxable vs. Non-Taxable Bonds: Which Sector is Optimal for My Investment Profile?
Next, you may be wondering about the difference between taxable and non-taxable bonds and how to know what is best for you.
The taxability of interest payments and capital gains and losses varies depending on several factors, including the:
- Specific type of obligation held
- Taxability status of the account, individual, or entity holding the obligation
- Cost basis
Corporate bonds are taxable by local, state, and federal governments. However, those issued by state and local governments, also known as municipal bonds, are typically exempt from federal and state taxation.
Taxable bonds usually pay higher coupon rates than non-taxable bonds. But a non-taxable bond could still provide a better net post-tax return. It’s essential to consider your tax bracket, which your financial advisor and tax consultant can assist you with.
What is Credit Risk?
Credit risk can be defined as the probability that an issuer will not honor its obligations. Credit analysis of the issuer’s financial strength and stability, credit scoring from established rating entities (e.g., Moody’s, S&P, and Fitch), collateral, and dedicated cash flows can all impact a bond’s credit risk.
What is Reinvestment Risk?
Reinvestment risk refers to the potential to receive cash flows in an environment of lower interest rates than those obtained by the retiring obligation at its origination. While reinvestment risk cannot be eliminated, it may be mitigated by utilizing a maturity ladder to spread cash flows over various time intervals.
Investment Grade vs. High-Yield Bonds: Which Sector is Optimal for My Investment Profile?
Credit scoring from established rating entities generally differentiates debt obligations as either investment grade or high-yield. Let’s look at the definitions and differences.
Investment grade obligations are deemed to be of higher credit quality. Investment grade categories are designated as AAA/Aaa, AA/Aa, and BBB/Baa. These bonds offer the lowest risk and are more likely to remain stable.
High-yield obligations will generally offer higher interest rates to compensate holders for higher levels of credit risk. High-yield categories fall below the investment grade designations and include BB/Ba, B/B, CC/Ca, and C/C.
Bringing Bonds to the Table
Don’t let the many definitions intimidate you from exploring bonds—after all, they could become a valuable addition to your portfolio! With some basic knowledge and support from an experienced wealth advisor, you can easily leverage the bond market.
If you have more questions about bonds or are ready for a new kind of tailored investment guidance, contact a Carlson advisor to get started today!
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