Individuals and institutions can use bonds in a variety of ways—from the most basic uses, such as capital preservation or saving and maximizing income, to more advanced uses, such as managing interest rate risk and diversifying investment portfolios. People sometimes think of ties as boring and outdated, and at the same time associate them with grandparents’ gifts.
Bonds may also be considered after the fact, especially during the flight to quality events, when investors flock to the safest bonds they can find to withstand financial turmoil. Bonds are much more complex than they seem, and they are versatile, providing investors in any investment environment with multiple options.
Read on for six ways to make bonds work for you.
- Bonds are an important part of a balanced and diversified investment portfolio.
- On average, compared with stocks, bonds help to preserve capital, with lower risk and volatility.
- Bonds generate income for investors who may need to rely on investment to generate cash flow to sustain their livelihoods.
- Bonds can also be used to speculate on changes in interest rates or to match future liabilities.
One of the most common uses of bonds is to retain principal. Although this concept is most applicable to bonds that are considered risk-free, such as short-term US government Treasury bills, investors can also apply it to other types of bonds. Unless any catastrophic event occurs, the bond can effectively preserve the principal.
Since bonds are essentially loans with a predetermined repayment period and maturity date, lenders (bond holders) can expect their bonds to maintain value and terminate at face value at maturity. (This is a simplified version of the bond life: with changes in current interest rates and the impact of bond values, significant fluctuations may occur). Risk-free bonds purchased at face value and held to maturity should be principal protected, mature at face value and provide reliable cash flow.
Historically, saving for the future has been one of the best uses of bonds. Savings bonds, as the name suggests, provide one of the safest and most time-tested long-term savings methods. They are fully trusted and guaranteed by the US government, and are sold in various forms, including discounts and interest payments. Savings bonds are designed to be held to maturity and are usually given to young investors as gifts to help them understand savings.
3. Manage interest rate risk
Interest rate risk is the inherent risk of all bonds, that is, bond prices will fluctuate with current interest rates. The reason for this risk is that the pricing value of the bond is the highest value of the present value of future interest payments and the principal returned at maturity. Because of this valuation, there is an inverse relationship between the current price of the bond and the prevailing interest rate.
For example, when the current interest rate rises, the price of bonds should fall under other conditions. This is a very simplified example of the relationship between interest rates and bond prices, and applies first to the highest quality bonds. In addition to changes in interest rates, other risk factors also affect the value of bonds, including credit, liquidity, and maturity.
Diversification is usually the most overlooked use of bonds. The generally low correlation between bonds and other asset classes makes bonds an excellent tool for diversification.
For example, you can create a simple portfolio of large-cap stocks and US government bonds, where the cross-correlation between assets is usually less than one. Although it is difficult to find two assets that are completely negatively correlated, the diversification between bonds and stocks can help calm those volatile market fluctuations, especially in the pursuit of quality.
5. Cost matching/immunization
Individuals usually use bonds to meet expected future cash needs. Institutions also use this strategy on a more complex basis, called immunization. The concept assumes that the duration of the bond matches the expected cash flow, which can be easily achieved by using zero-coupon bonds that match the duration of the bond. Although this will not provide any income during the bond’s validity period, it will provide a direct match.
6. Long-term planning
Compared with other asset classes, one of the advantages of bonds is that bonds have a predictable income stream that can be used to fund future expenditures of individuals and institutions’ corporate pension obligations. This is one of the reasons why financial institutions such as banks and insurance companies use long-term bonds for long-term planning. Compared with other asset classes, bonds enable them to match assets with liabilities with greater certainty (often referred to as asset/liability matching).
What are the risks of bonds?
Of course, none of these strategies will work if the bond’s coupon payment or return on its principal becomes uncertain. All quality bonds carry inherent risks, such as credit, default and interest rate risks. Buying only investment grade or US government securities can mitigate credit and default risks. It is worth noting that even bonds that are considered investment grade may soon fall below this standard. It is also possible to reduce interest rate risk simply by holding the bonds to maturity, as the face value will be returned at maturity.
Individuals and institutions can use bonds for long-term planning, capital preservation, savings, profit maximization, interest rate risk management, and investment portfolio diversification. If held to maturity, the bond will provide a predictable flow of coupon income and its full face value. Can your dull portfolio benefit from these “boring” types of investments?