Bond investing refers to a form of investment that is, in the essence, an investor lending money to a corporation (or sometimes a government) for a fixed term. The attraction of this type of investments is that most bonds pay a fixed monthly interest payment. This makes them a reliable income-generating asset.
When we talk about bond investing, of course, we are talking about investing in “investment grade” bonds. Buying bonds that are rated below investment grade is not so much investing as it is bond speculating.
Investment Grade Bonds
Bonds are rated by independent credit rating agencies such as Moody’s, or Standard and Poors. Ratings range from AAA to D, where D is a bond that is in default – not even making the monthly interest payments.
The ratings reflect the likelihood that the money invested in the bond will be repaid on the due date. A rating of AAA is the most secure. Bond investing is generally for the purposes of secure cash flow with low capital risk, so the rating is a very important consideration for bond investors.
Government bonds are generally rated at AAA plus, theoretically risk-free. In recent years, however, some rating agencies have actually lowered the rating of some government bonds to merely AA+, creating a storm of controversy in the investing community.
Ratings take into consideration interest rate risk, credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Bond investing, like any other form of investing, is all about managing risk.
Some governments have policies in place which actually increase the risk that they may find themselves unable to repay the bond when it falls due. Remember, when we are talking about bond investing in the region of multiple As that risk is still minuscule. But saying there is even a tiny risk that ten years from now the government may welch on a debt is a gutsy call for a rating agency.
Bond Investing – Junk Bonds
Bonds with a rating below BBB minus are called “junk bonds” in the bond industry. More formally referred to as “high yield bonds”, these bonds are issued by companies which are less secure financially. In order to compensate investors for the increased risk of loss, these bond issuers have to offer a higher rate of interest on their bonds.
Remember that bond investing is all about secure cash flow. Once the level of security drops below BBB-, bonds are not considered “investment grade” anymore.
This doesn’t mean that you should never buy junk bonds, but it does mean that you should not delude yourself that buying junk bonds is bond investing. As Mark Twain once said, “I am less interested in the return on my capital than the return of my capital.”
What is the benefit of getting a 10% return every year for ten years, only to lose your original investment?“Bond investing” by buying junk bonds is bond speculation, not bond investing.
The place of bond investing in a sensible investment strategy is to securely store cash in a vehicle that provides a regular monthly income. The older you are, the higher the proportion of your investment funds which should be in lower-risk, secure investments like investment-grade bonds. This makes it important to understand bond investments once you reach mid-life.