What Bonds Should I Invest In?
By : Jeremy Sorci | July 26, 2017
It is commonly known in the investment world that bonds, more often than not, are a safer investment than stocks.
A common question we get is, “what bonds should I invest in?” When shopping for bonds, it is imperative to keep two important concepts in mind:
- Safer does not mean guaranteed.
- Not all bonds are created equal.
Stocks vs Bonds: What’s the Difference to Your Comprehensive Financial Plan?
If you plan to invest in stocks and bonds, you should have a clear understanding of the difference between the two. Let’s consider an example. You could buy stock in Caterpillar or you could buy Caterpillar bonds. If you buy Caterpillar stock, you actually buy a very small fractional ownership interest in the company itself. Your ownership interest entitles you to share in the company profits through dividends, participate in the operation of the company through proxy voting, and assume the risk of success or failure through fluctuations in the price of your stock.
Purchasing Caterpillar bonds exposes you to less risk than purchasing stock because you do not have an ownership interest in the company. A bond purchase is essentially a loan. If Caterpillar needs to raise capital, for example, they will issue bonds as a way to do so. If you buy those bonds, you do so with the understanding that you will be repaid in full upon the bond’s maturity. You will also earn interest on the “loan” which may be paid out prior to, or upon, maturity of the bond. If Caterpillar becomes insolvent, bondholders have priority over stockholders. For this reason, bonds are generally considered a safer investment than stocks.
Rational Investors Know There’s No Such Thing as “Guaranteed”
While there are answers to the question, “what bonds should I invest in?”, most advisors know there is only one type of investment on the market that is “guaranteed” to be safe — the Certificate of Deposit, or CD. CDs issued by federally insured banks are insured by the FDIC for deposits of $250,000 per beneficiary, per institution. While that makes CDs a relatively safe investment, the word “guaranteed” must be considered in light of the following:
- The deposit is considered a deposit of the institution.
- Any money in a checking or savings account is part of the “per institution” deposit rule.
- Beneficiaries need to be clearly defined per the terms of the account.
- Just because you get married doesn’t automatically make a previously opened account a jointly owned account now.
- The beneficiary needs to be added before you invest an additional $250,000 to be considered FDIC insured for the full deposit.
- While highly unlikely, the FDIC could theoretically be unable to fulfill its obligations in the event of its own failure or mass financial institution insolvency.
US Government-Backed Bonds
Also known as agency bonds, these bonds are backed (not guaranteed) by the full faith and credit of the United States. Treasuries, Fannie Mae, Sally Mae, Freddie Mac, and Federal Farm Bureau are commonly recognized bonds of this type. Because of the high level of safety associated with these bonds, they typically don’t have as high of a return as a municipal or corporate bond. Some of these bonds provide partially tax-free income.
“Municipals,” or muni bonds, are issued by government municipalities such as states, cities, counties, or districts. These bonds come in two forms:
- General obligations – these are repaid through taxes received by the municipality.
- Revenues – these are repaid through the usage of utilities or structures.
These bonds often provide the funds needed to do things such as build bridges, improve/maintain infrastructure, or build a baseball stadium. Each type has its own risk factors to consider. The big draw to muni bonds is that the income generated by the investment can be state-tax exempt, federal-tax exempt, or both. As a rule, muni securities are not a good retirement account investment because you lose the tax-exempt benefit of the income earned upon distribution.
Corporate bonds are issued by the same companies that issue publicly traded stock. Since they are only backed by the assets owned by the company, they tend to be riskier than the aforementioned bond types. However, they typically offer a higher rate of return than other bond types.
High Yield Bonds
These should really be called high-risk bonds. Informed investors know these as junk bonds. These bonds have a credit rating of less than BBB on S&P’s rating scale. Because of their low credit rating, the companies issuing the bonds are required to pay investors higher rates of return. Unfortunately, the attractive title of these bonds is misleading, causing many investors to take on more risk than they realize.