How to Buy Bonds for Income and Diversity

Introduction

Bonds play an important role in investment portfolios by providing income and stability to balance out the volatility of stocks. While stocks offer higher long-term return potential, bonds provide steady interest payments and lower risk profiles. Adding exposure to bonds can reduce portfolio risk and generate cash flow from coupon payments.

This guide will walk through the bond basics – the types of bonds, how they work, where to buy them, strategies to consider, and how much bond allocation may make sense for different types of investors. Mastering how to incorporate bonds into your portfolio can improve long-term risk-adjusted returns.

What Exactly Are Bonds?

Bonds are debt investments where an investor loans capital to a bond issuer in exchange for promised interest payments and return of principal at maturity. The bond issuer is obligated to make these payments per the bond agreement. Major types of bond issuers include:

• Governments
• Municipalities
• Corporations
• Federal Agencies

Key terms to know in the bond market include:

Principal – The amount invested or lent to the bond issuer. Returned at maturity.

Coupon – The interest rate the bond issuer promises to pay on the principal annually.

Maturity – When the principal is due to be repaid. Often 1-30 years duration.

How Do Bonds Work?

Bonds provide periodic coupon payments at a fixed interest rate plus return the principal at maturity. A simplified example:

• Investor buys $10,000 bond with 5% coupon rate and 5 year duration
• The issuer pays $500 annually for 5 years (5% of $10,000)
• At year 5, the $10,000 principal is returned in full

Bond coupon rates compensate for inflation expectations and the creditworthiness of the issuer. Interest received can be spent or reinvested.

Why Invest in Bonds?

Bonds offer benefits for many types of investors:

Income – Steady interest payments distributed regularly, often quarterly or semi-annually. More predictable than stock dividends.

Stability – Bond prices fluctuate less than stocks. High credit quality bonds provide safety of principal not guaranteed in stocks.

Diversification – Bond prices often move independently from stocks. This lowers portfolio volatility when combined.

Tax Advantages – Certain bonds like municipal bonds have tax-exempt interest payments at state and federal levels.

Bonds diversify portfolios, hedge against deflationary periods, and provide income options to fund investor needs.

Types of Bonds

Many varieties of bonds exist. Some major types include:

US Treasury Bonds – Issued by federal government and considered virtually risk-free. Maturities range from 1 month to 30 years.

Municipal Bonds – Issued by local governments and agencies. Interest income is state tax-exempt. Credit quality varies.

Corporate Bonds – Issued by companies to raise capital. Range from high to low investment grade credit quality with commensurate yields.

Agency Bonds – Issued by federal agencies like Ginnie Mae, Fannie Mae. Considered very safe but yields are low.

High-Yield Bonds – Corporate bonds rated below investment grade with higher risk but higher yields.

Zero Coupon Bonds – Do not pay interest annually, instead reinvesting it to compound. Sold at steep discount to face value.

Key Bond Risks

While generally less risky than stocks, bonds do carry risks such as:

Interest Rate Risk – Bond prices fall as rates rise because new higher yield bonds become more attractive.

Inflation Risk – Inflation erodes the purchasing power of fixed coupon payments.

Call Risk – Bonds may be called by the issuer before maturity date if favorable to do so.

Default Risk – Issuers can default on interest payments and principal, especially with low credit quality bonds.

Liquidity Risk – Difficulty selling certain bonds due to low secondary trading volume.

Manage risks by favoring high credit quality bonds, limiting duration, and diversifying across many bonds.

How To Buy Individual Bonds

Beyond investing in bond funds, you can buy individual bonds directly:

Purchase Directly – Buy Treasuries at auction or existing bonds through brokerages like Fidelity, Vanguard

Use a Bond Ladder – Build a portfolio of bonds with staggered maturities to remain invested

Buy New Issuances – Research upcoming IPOs for corporate and municipal bonds to buy at issue

Utilize Online Trading Platforms – Sites like TD Ameritrade, E*Trade, and Charles Schwab facilitate online bond trading

Purchase Zero Coupon Bonds – Reinvest the compounded interest to grow bond value over time

Focus on highly rated investment grade bonds when investing on your own to mitigate default risks.

Active Bond Investment Strategies

More advanced bond investors implement active strategies to pursue outperformance:

Build Barbell Portfolios – Pair long and short duration bonds to benefit from yield curve changes

Utilize Leverage – Employ conservative leverage to amplify yield

Tactically Manage Duration – Adjust bond portfolio duration based on interest rate outlooks

Swap Sectors Based on Valuations – Rotate between corporate, Treasury, and municipal bonds

Invest in International Bonds – Add geographic diversification with foreign sovereign and corporate bonds

Take Advantage of Mispricings – Look for bonds mispriced relative to peers to benefit from reversion to fair value

Active approaches require understanding drivers of bond valuations and markets to profit from pricing inefficiencies.

Passive Bond Investment Strategies

Taking a passive approach to bond investing also has merits:

Buy and Hold – Hold a diversified bond portfolio long term instead of trading actively.

Bond Index Funds – Invest in low-cost bond index mutual funds or ETFs like BND or AGG for broad exposure.

Target Date Funds – Use target date or life cycle funds that automatically adjust bond allocations over time.

Reinvest Interest – Reinvest interest received to compound growth over time through the power of reinvesting.

Regularly Rebalance – Maintain desired asset allocation between stocks and bonds over time through rebalancing.

Passive strategies are lower effort means to incorporate bonds for stability and income.

What is the Best Bond Allocation?

Bond allocation should increase with your age and need for income and stability:

• 20s & 30s – 10-30% in bonds to start introducing stability
• 40s & 50s – 25-50% as growth needs decrease and income needs may arise
• 60s & 70s – 40-60% to reduce risk as retirement nears while still growing the portfolio

Your specific asset mix should also consider risk tolerance, time horizon, goals, and external income sources.

Conclusion

Adding high-quality bonds to an investment portfolio provides steady income, diversification benefits, and reduced volatility. Stick to highly-rated government and corporate bonds as a beginner investor. Consider both passive index-based and active bond investing tactics. Use bonds to balance out the growth-oriented portion of your portfolio allocated to stocks and other alternatives based on your age, time horizon, and goals. Done right, investing strategically in bonds can provide ballast and income to smooth out the long-term ride for any investor.