Bond Funds: Smart Move For Your Uninvested Cash?

Investing in a bond fund is a great way to diversify your portfolio and reduce risk. But is it the right choice for your uninvested cash?

Bonds are a way for organisations to raise money. They are debt securities that entitle the holder to interest payments. Investing in bonds can help lower risk when compared to stocks and provide stability in a portfolio.

There are different types of bonds, each with its own benefits and drawbacks. For example, corporate bonds tend to offer higher interest rates than other types, but the companies that issue them are more likely to default than government entities.

On the other hand, bond funds are managed by professionals and allow you to invest in a range of bonds with a low minimum investment. However, they usually include higher management fees and commissions, and the income can fluctuate.

So, should you invest your uninvested cash in a bond fund? It depends on your financial goals, risk tolerance, and investment horizon. If you're looking for a well-diversified portfolio with less control over specific investments, a bond fund could be a good option. But if you prefer more control and transparency, buying individual bonds may be a better choice.

The pros and cons of investing in bonds

Bonds are a type of investment that can offer a steady and predictable income stream with relatively high returns compared to other low-risk options. They are often used to create a diversified portfolio when combined with stocks. However, like any investment, there are risks involved.

Pros of Investing in Bonds:

• Safety: Bonds are considered a relatively safe investment as their values don't fluctuate as much as stock prices.
• Income: Bonds offer a predictable and fixed income stream, usually paid twice a year. This can be helpful for investors who rely on this income for daily expenses or can be reinvested.
• Community Impact: Municipal bonds can have a positive impact on local communities, funding projects like improving schools, building hospitals, or developing public gardens.
• Diversification: Bonds bring diversification to an investment portfolio. While stocks have historically outperformed bonds over the long term, a mix of both reduces financial risk.
• Lower Risk: Bonds tend to be less risky than stocks, especially federal bonds, which are sometimes considered "risk-free" as governments can print money. Local and state bonds are slightly riskier but defaults are rare.

Cons of Investing in Bonds:

• Less Cash: Bonds require locking away money for extended periods, reducing access to cash.
• Interest Rate Risk: Bonds are long-term investments, so there is a risk of interest rate changes. If interest rates increase after purchasing a bond, its value will drop.
• Issuer Default: Although uncommon, there is a risk of the issuer defaulting on their obligations, resulting in a loss of interest payments and/or the principal amount.
• Transparency: The bond market has less transparency than the stock market, making it challenging to determine fair prices, and brokers may charge higher prices.
• Smaller Returns: The return on investment from bonds is typically lower than stocks.
• Values Drop with Rising Interest Rates: A bond's value can drop when interest rates rise as people prefer newer bonds with higher interest rates.
• Inflation Risk: Rising inflation can decrease the value of the fixed income received from the bond over time.
• Early Call Risk: Some bonds can be called early, meaning the issuer repays the bond before maturity, disrupting the expected income stream.
• Limited Control: Investing in bond funds offers less control over the specific bonds in the portfolio compared to buying individual bonds.

The different types of bonds

There are several types of bonds, each with its unique characteristics and advantages. Here are some of the most common types:

• Corporate bonds are issued by corporations to finance their operations or expansions. They are considered fixed-income securities, and investors who buy these bonds lend funds to the company in exchange for interest payments and the return of the principal at maturity. The risk and return of corporate bonds vary, usually depending on the issuing company's creditworthiness.
• Treasury bonds, or T-bonds, are long-term investments issued by the US government, typically with maturities of 10, 20, or 30 years. These bonds are backed by the US government and are thus considered very safe. Due to their low risk, they offer lower yields than other types of bonds.
• International government bonds are issued by foreign governments, allowing investors to diversify their portfolios geographically. These bonds can potentially benefit from currency fluctuations or higher yields, but they may also carry additional risks, such as political instability and exchange rate volatility.
• Municipal bonds, often called "munis", are issued by states, cities, or counties to fund public projects or operations. They provide a steady interest cash flow for investors and typically offer tax advantages, as the interest earned is often exempt from federal, state, and local taxes.
• Agency bonds are issued by government-sponsored enterprises or federal agencies. Although they are not directly backed by the US government, they are considered safe due to their government affiliation. These bonds finance public-purpose projects and usually offer higher yields than Treasury bonds. However, they may carry a call risk, meaning the issuer can repay the bond before its maturity date.
• Green bonds are issued to fund environmentally friendly projects, such as renewable energy or pollution reduction. They are similar to regular bonds, but the funds are specifically earmarked for green initiatives.
• Bond ETFs (Exchange-Traded Funds) invest specifically in bond securities, offering broad diversification within the bond market. An ETF may hold a range of different bonds, providing liquidity, price transparency, and lower investment thresholds than individual bonds. However, like individual bonds, they are subject to interest rate and credit risk.

How to buy bonds

There are several ways to buy bonds, including through a broker, an ETF, or directly from the government.

Through a Broker

Bonds can be purchased from a bond broker through full-service or discount brokerage channels, similar to how stocks are bought from a stockbroker. Many brokers now give investors access to purchase individual bonds online. However, dealing with a bond broker can be costly for some retail investors. Buying bonds individually can be challenging for individual or inexperienced investors, so purchasing through a brokerage can simplify the process.

Through an ETF

An ETF (exchange-traded fund) or a mutual fund is one of the simplest ways to invest in bonds. These funds are convenient as they are usually low-cost and contain a broad base of diversified bonds, so you don't need to do your research to identify specific issues. A fund is a great option for individual investors because it offers immediate diversification, and you don't have to buy in large increments.

Directly from the Government

Government bonds can be purchased directly through government-sponsored websites without the need for a broker, though they can also be found as part of mutual funds or ETFs. In the US, for example, Treasury bonds and bills (T-bonds and T-bills) can be purchased through TreasuryDirect. No fees or commissions are charged, but you must have a Social Security number, a US address, and a US bank account.

What to Consider When Buying Bonds

Creditworthiness and Financial Health

Before buying a bond, it's important to assess the creditworthiness and financial health of the issuer. Bonds are rated by ratings agencies such as Moody's, Standard & Poor's, and Fitch, which assign credit ratings based on the estimated ability of the issuer to meet its debt obligations.

Interest Rates and Market Conditions

The prevailing interest rates and market conditions will impact the price of bonds. Generally, when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This is because existing bonds with lower interest rates become less desirable when newer bonds are offering higher rates.

Maturity and Term

The term of a bond refers to the length of time until it matures. Longer-term bonds tend to offer higher interest rates due to their greater interest rate risk. Short-term bonds, on the other hand, may be less volatile and more suitable for investors seeking a steady income stream.

Diversification

Diversifying your bond portfolio can be challenging due to the large units in which bonds are typically sold. Buying bond ETFs or mutual funds can provide exposure to a variety of bond types and help mitigate the risk of placing all your investments in one basket.

Costs and Fees

Buying bonds through a brokerage can come with associated costs, including account maintenance fees and commissions on trades. Broker commissions can range from 0.5% to 2% of the transaction value. Additionally, some specialized bond brokerages require high minimum initial deposits, typically around $5,000.

Strategies for Buying Bonds

Bond Laddering

Bond laddering involves buying multiple bonds with staggered maturity dates to manage interest rate risk and cash flows. By spacing out the maturity dates, you won't be locked into one bond for an extended period, and you can reinvest the proceeds at regular intervals.

Matching Coupon Payments and Maturities to Income Needs

If you're willing to sacrifice some yield for a risk-free portfolio, you can use Treasury bonds to structure coupon payments and maturities that align with your income requirements. This minimizes reinvestment risk and ensures a steady stream of income.

Types of Bonds

There are several types of bonds to consider for your investment portfolio:

Corporate Bonds

Corporate bonds are issued by businesses and typically offer higher interest rates than other types of bonds. However, the companies that issue them are more likely to default than government entities.

Municipal Bonds

Municipal bonds, or muni bonds, are issued by states, cities, and local governments to finance public projects or offer public services. They are often used to fund projects such as building bridges or parks.

Treasury Bonds

Treasury bonds, also known as T-bonds, are issued by the US government. Due to the lack of default risk, they generally offer lower interest rates than corporate bonds.

Zero-Coupon Bonds

Zero-coupon bonds are sold at a deep discount to their face value and do not pay periodic interest. Instead, investors profit from the difference between the purchase price and the amount received at maturity. Treasury bills are an example of zero-coupon bonds.

The risks of investing in bonds

Investing in bonds is generally considered less risky than investing in stocks. However, there are still several risks associated with investing in bonds that prospective investors should be aware of. Here are some of the main risks of investing in bonds:

Interest Rate Risk

Rising interest rates can lead to falling bond prices, as investors can obtain more attractive rates of return on their money elsewhere. Conversely, falling interest rates can result in rising bond prices and lower yields. Before investing in bonds, it is crucial to assess the potential price volatility resulting from interest rate fluctuations.

Reinvestment Risk

When interest rates decline, investors may need to reinvest their coupon income and principal at lower prevailing rates, potentially impacting their overall returns.

Inflation Risk

Inflation erodes the purchasing power of a bond investor's future interest payments and principal, collectively known as "cash flows." Inflation also often leads to higher interest rates, which, in turn, cause bond prices to decrease. Inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS), are designed to mitigate this risk by adjusting the coupon stream and principal in line with the inflation rate.

Credit/Default Risk

This is the risk that the bond issuer will be unable to make interest or principal payments when they are due, resulting in a default. Rating agencies assess the creditworthiness of issuers and assign credit ratings to bonds, with AAA being the highest and D being the lowest. Bonds with lower credit ratings are considered more speculative and subject to greater price volatility.

Liquidity Risk

Liquidity risk is the potential difficulty investors may face in finding buyers when they want to sell their bonds. This risk is typically lower for government bonds than for corporate bonds due to the larger issue sizes of government bonds. However, the sovereign debt crisis has reduced the liquidity of government bonds issued by smaller European peripheral nations.

Market Risk

Market risk refers to the possibility of a decline in the bond market as a whole, which would negatively impact the value of individual bonds regardless of their fundamental characteristics.

Selection Risk

Selection risk is the chance that an investor chooses a bond that underperforms the market for unforeseen reasons.

Timing Risk

Timing risk is the risk that a bond performs poorly after it is purchased or better after it is sold, impacting the investor's overall returns.

Call Risk

Some bonds, particularly corporate, municipal, and agency bonds, have a "call provision" that allows the issuer to redeem the bond at a specified price before its maturity date. Declining interest rates may accelerate the redemption of a callable bond, forcing investors to reinvest their principal at lower rates.

Event Risk

Event risk is the possibility that a bond issuer undergoes a leveraged buyout, debt restructuring, merger, or recapitalization that increases its debt burden or affects its ability to make timely interest and principal payments. Event risk is more commonly associated with corporate bonds than municipal bonds.

Prepayment Risk (for mortgage-backed securities)

In the context of mortgage-backed securities, declining interest rates or a robust housing market may prompt mortgage holders to refinance or repay their loans earlier than expected, leading to an early return of principal to bondholders.

Contraction Risk (for mortgage-related securities)

Contraction risk is relevant for mortgage-related securities. When interest rates decline, the assumed prepayment speeds of mortgage loans may accelerate, resulting in an early return of principal to investors, who then need to reinvest at lower rates.

Extension Risk (for mortgage-related securities)

On the other hand, rising interest rates may slow down the assumed prepayment speeds of mortgage loans, causing a delay in the return of principal to investors. This extension risk can cause investors to miss out on opportunities to reinvest at higher yields.

Negative Convexity Risk (for callable and mortgage-backed securities)

Callable bonds and mortgage-backed securities have negative convexity, which means that their price-yield relationship is convex rather than concave. Negative convexity creates extension risk when interest rates increase and contraction risk when interest rates fall.

Early Amortization Risk (for asset-backed securities)

Early amortization of asset-backed securities can be triggered by events including but not limited to insufficient payments by underlying borrowers and bankruptcy on the part of the sponsor or servicer. In early amortization, all principal and interest payments on the underlying assets are used to repay investors, typically on a monthly basis, regardless of the expected schedule.

How bonds compare to stocks

Stocks and bonds are two of the most traded types of assets, each available for sale on several different platforms or through a variety of markets or brokers. Here are some of the key differences between the two:

Nature of Investment

Stocks represent ownership, while bonds represent debt. When a company issues stock, it sells a piece of itself in exchange for cash. On the other hand, when a company issues a bond, it issues debt with the promise to pay interest for the use of the money.

Returns

Historically, stocks have tended to earn more than bonds, especially in the long term. Stocks can offer better returns if the company grows exponentially, earning investors potentially millions from a minuscule initial investment. Bonds, on the other hand, don't have as much income potential as stocks, which can multiply in value overnight.

Risk

Bonds are generally considered a lower-risk option compared to stocks. Stocks are often riskier in the short term, given the amount of money an investor could lose virtually overnight. Bonds, with their fixed interest rates, are considered safer in the short term or for new investors.

Trading

Stocks are typically traded on various exchanges, while bonds are mainly sold over the counter (OTC) rather than in a centralized location. In the US, prominent stock exchanges include Nasdaq, the New York Stock Exchange (NYSE), and the American Stock Exchange (AMEX). All of these markets are regulated and kept in check by the Securities and Exchange Commission (SEC).

Volatility

Individual stocks and the overall stock market tend to be on the riskier end of the investment spectrum in terms of their volatility and the possibility of the investor losing money in the short term. Bonds, on the other hand, are more susceptible to risks such as inflation and interest rates. When interest rates rise, bond prices tend to fall.

Frequently asked questions