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Are You Missing The Point Of Bond Investing?

If you take a look at any successful portfolio, you will see a mix of stocks and bonds. While perhaps not as sexy as their equity counterparts, the value and importance of bonds is often overlooked by the rags to riches or in many cases, the riches back to rags story of stocks.

In a nutshell, bond investing involves lending money to a corporation, for a fixed term, and getting a fixed rate of return. This return on your investment is called the coupon rate. The key is in knowing how much of your portfolio should be invested in bonds and how much should be invested in the stock market.

The principle advantage of bonds is that they're rated in their risks. The bond has a term where it pays off (say 10 years) at which point you get your initial investment back. Bonds will pay a steady income of whatever their return rate is, taken as a percentage of the initial investment. Thus, if you invest $100 000 in a series of bonds that return interest at a coupon rate of 3.5%, each year, you'll get $3 500 of interest income. The big advantage of bonds is their steady income stream, and that you get the initial investment back when you're done.

Sounds simple, right? Here's where it gets a bit more complicated, but, more profitable. The key is in establishing what is the best strategy when it comes to investing in bonds. The answer of course, is it depends! What types of bonds are you looking at buying? Short term (which are less than 5 years in length of term) usually have a low coupon rate, however, your investment isn't tied up for a longer duration. This may prove helpful if there is a chance that you may need access to your funds in the case of an emergency, as odds are, you will have a bond maturing around the time you'll need it most. Medium bonds can tie up your money for 5-10 years, while long term bonds can enjoy a term of 10-30 years. The coupon rate will also vary depending on the credit worthiness. A lower credit rating often means a higher coupon rate (to match the higher risk involved), while a high credit rating is rewarded with a lower coupon rate (and less volatility and risk).

While the coupon rate is the most understand concept in bond investing, its not necessarily where all the money is made. Remember, people buy and sell bonds well before their maturity date. As such, when the interest rate moves lower, the price of an existing bond moves higher, thanks to its higher rate of return than a newer bond would provide. On the flip side, if interest rates move higher, the bond price moves lower, simply because new bonds will now provide a higher rate of return than your existing ones. If you make the call on the direction of interest rates correctly, you'll find yourself in the money by a few percentage points. That can make a huge difference in your portfolio.

Finally, there's the yield of the bond, which is a bit more involved, but simple to calculate. The yield rate is the ratio of the annual return of the coupon rate divided by the current purchase price of the bond. For example, that $100 000 bond with an annual payout of $3 500 has a yield of 3.5% if it's bought at $100 000. If it were purchased at $90 000 (due to an increase in interest rates), it would still return $3 500 per year, and would have a yield of $3 500/$90 000 = 3.8%. Just like the purchase price varies inversely with the interest rate, so does the yield.

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