After discussing stocks in last weeks’ blog (How to Build a Stock Portfolio?), this week I want to cover fixed-income investments.
For many people, this term is unknown, but essentially what fixed-income investment means is investing in bonds. The reason why this is called fixed income is very simple, and it is because of the promise of an institution (corporation or government) to deliver periodically a specific amount of money based on your initial investment. Let's see a more in-depth description.
What are bonds?
A bond is a loan. You, as an investor, are lending your money to an institution. Companies have access to funding through equity (stocks) or loans (bonds among others). Corporations have both equity and bonds, while governments can only issue bonds in the stock market. The money that you invest (principal) will be returned at the end of the investment period if you decide to keep it until it expires. Additionally, These type of investments have specific characteristics:
Time: Unlike stocks, bonds do have an expiration date (maturity). You can have a bond with maturity of a few months or even decades.
Coupon: Another unique characteristic about bonds is that the institution that takes your money will be committed to give you a specific amount of money on a specific day (coupon). The amount of this money will vary depending on the initial characteristics of the bond. On average this coupon will be in a range between 2% and 7% of your investment.
Why investing in bonds?
In general, and according to theory, bonds tend to have an inverse relationship with stocks. A drop in stocks would mean a higher price for bonds. Then, in essence, bonds will provide some stability to your portfolio when stocks fall. This is why portfolio allocation includes bonds too: risk mitigation. The extent to which fixed-income ought to weight into your portfolio will vary upon your liquidity needs and risk profile (what type of investor are you?).
However, not all bonds are the same and, as it is the case for stocks, you can find a wide variety of bonds, each with different risk levels. These levels would be determined by credit rating agencies, which give a score to the company issuing each bond. There are at least 21 subcategories that are grouped into two main categories: Investment grade (with the highest score) and High Yield (with the lowest score). Around the world, the US treasury 10 years bonds are the most known in the investment-grade category.
Another reason to invest in bonds is income: many people want to invest but do not want to have high risks. Instead, they look for the most secure type of investment as long as they receive something back in return. Examples of people within this category would be people with money for future education (they don't want to take high risks but want to have some gains in the meantime), people that do not feel good investing in stocks or people that want to receive some extra money periodically.
Risks investing in bonds
As an investment, bonds do also carry some risks. These include:
Default: institutions might go bankrupt. However, unlike stocks, bondholders have a priority. That means that if the company goes bankrupt, the investor will have the money back, although it can take (in the worst-case scenario) a long time.
Interest rate: As bonds act like a loan, the movement in central bank rates could affect your investment.
Inflation: If inflation increases more than your interest coupon rate, it means that you have a negative return. That is why the term is very important when investing in fixed income securities.
Ratings: the company’s performance, its balance sheet, and variables that help the business can change. Whether it is good or bad, the credit rating agencies could modify the score they have for the issuers, which at the end will result in a modification of your initial investment.
As we see, fixed-income investments or bonds can be a great resource of mitigating risk within a portfolio and a good way to generate income. However, a good understanding of each type of bond is a must for you to have a holistic comprehension of how your portfolio can change if something in the economy changes too.
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