In terms of popularity, bond portfolios are usually inferior to stock portfolios. Although they play a vital role in overall asset allocation, bonds do not seem to receive the same attention as their stock-based counterparts. They are usually constructed as an afterthought, or stay the same over the years to generate revenue. This is unfortunate, because bonds provide a hybrid-sharing and mixing the risk and return characteristics of stocks and cash.
A properly constructed bond portfolio can provide income, total returns, diversify other asset classes, and be as risky or safe as the designer hopes. The fixed income market is as diverse and exotic as the stock market.
- Bonds are an important part of a balanced investment portfolio.
- Bonds generate higher returns than bank accounts, but the risk of a diversified bond portfolio is still relatively low.
- Generally speaking, bonds, especially government bonds, can diversify stock portfolios and reduce losses.
- Bond ETFs are a simple way for investors to obtain income from bond portfolios.
How a fixed income portfolio works
First, bonds are designed to provide income to bondholders in exchange for lending funds to the issuer. The issuer’s coupon payment path is passed to the transfer agent, bank and bondholder. In the simplest form, a 3% bond with a face value of US$1,000 is traded at its face value and will generate an income of US$30 (3% of US$1,000) for the holder each year in the form of coupons.
It’s easy to forget that the word “coupon” used to refer to actual coupons cut from bonds. In the early 20th century, bondholders received a coupon book with bonds, and they could go to the bank to show the coupons for payment or deposit. This process has been developed to not only make it easier to buy and sell bonds, but also to obtain coupons as income more easily. Bonds are now held under so-called street names, which provides an easier and safer way to hold bonds.
Bonds can also be used as collateral for loans in an account, including margin loans used to purchase other bonds, stocks and some funds. Bonds have a wide range of uses and are an excellent liquidity tool to achieve investment goals.
Bond income and taxes
Bond income can be taxed at the federal tax rate or exempt from federal tax. In addition, there are many differences between state and local taxation. Generally speaking, bond income should be taxed as income, whether it is declared as an individual or as a company. This is detrimental to bonds, because people who favor stocks will quote the current bond market’s actual yields as negative.
Although this sounds impossible, here is an example:
This example shows that a principal of $100,000 is invested in a bond that pays a 4% coupon and is taxed at the federal and state levels. After subtracting the loss of purchasing power from 3% of the Consumer Price Index (CPI) value, the actual rate of return is negative. However, please note that there is some controversy regarding CPI as a measure of inflation.
On the other hand, using coupon bonds with tax exemptions at the federal and state levels will produce different results:
|State tax||0 USD|
|Federal tax||0 USD|
|Actual return||1,000.00 USD|
It is also possible to avoid taxation of bond income by depositing bond income in a tax-exempt retirement account (such as a Roth IRA).
How bonds benefit investors
Although it is positive, considering the potential gains in the stock market, a 1% return is not very impressive. These examples will quickly discourage novice investors. However, there are reasons why both individual and institutional investors need bonds as part of a balanced portfolio. The main reason is that coupon income is only a component of the total return of the bond portfolio. In addition, the low correlation between bonds as an asset class and stock asset classes provides some stability through diversification.
The total return of a bond portfolio is the overall change in its value over a specific time interval, including income and capital appreciation or depreciation. Fluctuations in market value, as well as the final risk characteristics, will be affected by the interest rate measured by the yield curve. The interest rate environment is dynamic. Therefore, the source of returns is not just the current interest rate on the static yield curve. It also includes price changes caused by fluctuations in interest rates over a period of time.
As an asset class, bonds help diversify the overall investment portfolio because they are less relevant to other asset classes. When the stock market crashes, the lonely bond portfolio is always the brightest. Although correlations vary greatly over time, bonds are not highly correlated with any other asset class. Even in the simplest diversified portfolio, bonds can reduce volatility because they have a low or negative correlation with stocks. The more investors understand about diversification, the more likely they are to add bonds to their portfolio.
Use ETFs to simplify bonds
Investors don’t have to be bond geeks or learn how to become bond traders to buy bond ETFs. Bond ETFs can be purchased like stocks and give investors immediate access to a ready-made bond portfolio. Integrated bond ETFs provide access to the entire investment-grade bond market. They are ideal for investors looking for relatively low risks and higher returns than currency markets. However, those who want to protect their holdings are better off choosing government bond ETFs. Government bonds usually increase in price when stock prices fall, and therefore provide more protection.
Bonds are often seen as a less glamorous partner to stocks. Many investors think bonds are boring and complicated, but ETFs make them easy. There are also many interesting options in the bond market. Buying US government bonds during a stock bear market may be more profitable and exciting than waiting for cash. When investors expect the bear market to end, junk bonds are usually a higher return and lower risk option than stocks. Finally, a highly diversified bond portfolio is a simple method with a little more than cash but a little more risk.