Bonds are included in investment portfolios for a wide variety of reasons. For example, people who are looking for a lower-risk way to invest may decide to put some investment dollars into bonds, perhaps to generate regular interest income.
Plus, people who want to balance their portfolios with a mixture of stock investments—which can come with higher levels of risk, as well as higher potential returns—with some steady investment vehicles may also buy bonds. And, those are just two examples of why people might choose to invest in bonds.
But what are bonds, exactly? Who issues them? What should you consider when buying them? And, what are the different types—including the differences between a secured bond vs. an unsecured bond? How do they fit within differing types of portfolios?
Investors can typically buy bonds in four categories:
• Treasury bonds: These are issued by the United States government.
• Corporate bonds: These are issued by a corporation.
• Municipal bonds: These are issued by a governmental entity, either state or local, or an agency; the latter can be a school district, a water authority, airport, and so forth.
• Mortgage bonds/asset-backed bonds: These would pass through interest on a financial asset, whether a mortgage bundle or another type of financial asset, such as car loans, student loans, or a company’s accounts receivable.
When an investor buys bonds, he or she is lending money to the issuer. Terms on these loans vary, just as they do on other types of loans. In general, though, the investor is lending a government, corporation, agency, or financial institution money for a period of time and receiving a predetermined amount of interest during the term.
Here’s an example. If an investor buys a corporate bond that provides a 4% interest rate, with a term of 15 years, this means that the purchaser would receive an annual interest amount of $40 for each $1,000 invested. Then, when the bond matures at the end of the term, the investor would also get the original investment returned.
Note that some bonds can be “callable,” which means that the issuer has the option to repay investors the face value of the bond before the maturity date arrives.
Bonds can differ in levels of risk and return. Overall, bond sales that come with more risk promise a greater return, while ones that are more secure typically have a lower rate of return.
Bonds issued by the federal government, for example, are considered a lower risk than those from a newer corporation—so investors wanting a safer route could choose the first while ones wanting more return (who are willing to take more risk) might choose the second. Or, investors can buy bonds from a mixture of issuers.
Here’s another way to classify bonds: whether they’re secured vs. unsecured bonds.
Secured Vs. Unsecured Bonds
A secured bond is one that has an asset as collateral to back up a person’s investment. This asset can be something physical, such as a piece of property or equipment, or an income stream. A government agency, as an example of the second type, might issue bonds to raise money to build a bridge.
The bonds could be secured—but, in this case, not by the bridge itself; rather, by the future revenue stream that will be generated after construction is complete when a toll will be charged for people to drive over that bridge.
This type of bond can sometimes be referred to as a revenue bond. These are often considered non-resource—meaning that, if the source of revenue dries up, the investor often doesn’t have an ability to get paid.
And, a bond can actually be secured by both a physical asset and an income stream. An example of bonds that are secured by both is a bundle of mortgage loans. This has the physical property being mortgaged by borrowers as collateral, as well as the income stream that comes in when people make their mortgage payments.
A key benefit of choosing a secure bond is that, if the entity issuing the bond defaults on making payments to bond purchasers, then the investors can attempt to collect from the assets of the issuer to get their money.
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The process isn’t necessarily as straightforward as an investor owning bonds in default might like, however, in part because the collateralized assets may not be significant enough in worth to cover the totality of what’s owed—and in part because issuers may challenge the investors’ right to those assets. So, in reality, it can take weeks to months, or even longer, to actually get bond-related money from an issuer in default.
Investors who want to purchase secured bonds typically seek them out from corporations and municipalities. That doesn’t mean, however, that all corporate bonds are secured; in fact, many of these types of bonds are in fact unsecured.
Unsecured bonds are those that don’t have assets backing them. Instead, investors are given the “full faith and credit” of the entity issuing them that the bonds will be paid upon, as promised. U.S. Treasury Bonds, for example, are considered unsecured (although these are also considered one of the lowest risk investments available).
If the issuer of an unsecured bond defaults, owners of these bonds would still have a claim on the issuer’s assets, but are paid only after holders of secured bonds are paid.
From a risk and return perspective, it might seem as though secured bonds present a lower risk because they have collateral behind them. There may be some truth to that, but investors wanting low risk often buy Treasury bonds—unsecured investments—because the U.S. government has made all scheduled payments over the past 200+ plus years.
When choosing what bonds to buy, here’s guidance: as a generalization, debt that’s considered riskier will offer more attractive interest rates. Those backed by entities with strong economic profiles will have relatively lower rates. And, although “secured” sounds more reliable than “unsecured,” the reality is that a secured bond of “junk” quality is actually riskier than an investment grade unsecured bond.
A person’s goals when investing, including when choosing bonds, should help to guide which ones make sense to purchase.
Benefits of Investing in Bonds
Two key benefits of purchasing bonds, whether secured or unsecured, are how they can:
• be a source of income
• reduce volatility of a portfolio (more about asset allocation soon)
Bonds pay a fixed interest rate, typically paying investors twice a year, which creates the income that a bond holder may want. Plus, because they are typically lower in risk than stocks, they can help to reduce the overall levels of risk in an investor’s portfolio.
Because a person’s risk tolerance plays a significant role in the type of investing that is best for them, investors can use this risk tolerance quiz as a way of analyzing the degrees of risk that feel comfortable for them.
To help investors understand how much risk is associated with a specific bond purchase, bond ratings were developed.
There are currently three different agencies (Moody’s, Standard and Poor’s, and Fitch Ratings) that provide independent assessments of the financial ability of a bond issuer to meet commitments being made.
Although each agency assesses a bond somewhat differently, they each provide approximately ten different credit grades. The credit rating of the bond issuer may be the most important factor in these assessments. Issuers may be rated as investment grade, for example, if they are financially solid, or in default, if significant problems exist.
How Bonds Factor into Asset Allocation
Savvy investors typically create diversified portfolios, which contain a mix of assets, often including stocks and bonds with varying levels of risk and reward.
Diversification is the financial version of not putting all eggs in one basket, with asset allocation referring to the amount of money invested into each type of asset class within a person’s portfolio.
Individual investors can each decide what asset allocation makes the most sense for them, perhaps including 60% stocks and 40% bonds, as just one example.
Factors involved in determining asset allocation include an investor’s
• Financial goals
• Risk tolerance
• Investing timelines (when retirement is looming, for example, asset allocations may be different than for a younger investor)
By looking at these factors, along with possible investment options and their historical performances, an investor can choose a mix of assets that seem to dovetail best with his or her unique goals, challenges, and overall financial situation.
Asset Allocation Models
There are four broad asset allocation models that can be shared to show varying investment strategies. Some, but not all of them, typically include bonds.
Capital Preservation Portfolio
As the name suggests, an investor creating this type of portfolio wants to preserve capital, and is averse to losing money, even short term.
This can be the type of portfolio created for investors who have short-term goals (meaning, those intended to be accomplished within one year), such as someone building an emergency fund, or saving to buy a car. Investors with capital preservation goals might put an entire portfolio in a money market fund because stocks and bonds alike can have short-term losses.
Income Producing Portfolio
Investors using this strategy typically focus on generating income, rather than portfolio growth, often because they will be living off investment income to some degree. For example, someone who is already retired might invest in income producing vehicles to supplement a monthly pension.
This person’s portfolio might include bonds, whether secured or unsecured, from government entities or corporations with a history of steady profitability. Other elements of the portfolio might include shares of stocks that pay dividends and/or real estate investment trusts.
As a third investment model, a growth strategy can be chosen by people who want long-term portfolio growth. These investors may be willing to take more risk than those who fit into one of the two previous models described if they believe they can receive higher returns.
This investor may still be working and therefore not need to have their portfolios generate income yet. A portfolio focusing on growth may largely or even fully have stock investments.
This type of portfolio can be a blend of an income-producing and a growth portfolio. People of all ages along the investment journey may choose to use a balanced approach to manage portfolio volatility, and this type often contains a mix of common stocks with investment-grade bonds.
This type of portfolio, in other words, is created to balance assets that grow over time with less volatility with those that can produce growth.
Stock and Bond Allocation “Rule”
Financial advisors sometimes use formulas to determine the best mix of stocks and bonds in a portfolio for an investor. One such “rule” is to subtract the investor’s age from 110.
The number that remains may indicate the percentage of a portfolio that should go into buying stocks. So, while a 30 year old may use this to put 80% of funds into stocks, a 60 year old—using the same formula—would put in only 50%.
The remainder could be invested into a more conservative choice: bonds. Because different people have different risk tolerances, this is not a hard and fast rule; rather, it’s a starting point when deciding how aggressive or conservative an investor wants a portfolio to be.
Investment Options at SoFi
People can invest online with ease with SoFi Invest®, creating a diversified portfolio that dovetails with risk tolerance levels. Portfolios are reviewed quarterly to see if an asset allocation is more than 5% off of its original allocation, rebalancing portfolios where this proves to be true.
Portfolios may be rebalanced more often if an asset class experiences a significant change, with the goal always being to keep an investor’s portfolio on track with stated goals.
Having said that, investors can decide to change investment strategies at any time. And, when they have questions, they have access to financial planners at no additional cost.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.