Basics of Bonds
If you are interested in investing, then you would certainly have heard of bonds. Bonds are among the most common financial instruments and are a very popular investment class. The reason for this is quite simple – bonds offer many attractive opportunities for investors and are a very flexible investment option. As a result, many investors (if not all) realise that bonds can be a beneficial (profitable) addition to their portfolio. In this article, we will look at how you can take advantage of bonds and use them in your portfolio. Thus, we will see how you can design a balanced portfolio using bonds only. So, let us first understand what bonds are.
A bond is a lending instrument. Buying a bond is equivalent to lending a certain sum of money to the issuer of the bond. In turn, the issuer periodically pays you a fixed sum of money (the interest effectively). Bonds typically have a fixed period of maturity. At the end of the period of maturity, the issuer of the bond would return the original sum of money to the purchaser of the bond.
Bonds can be issued by many different entities. Typically, bonds may be issued by the central government (union government), local governments, government bodies, corporate entities, etc. Bonds issued by the central government are often seen as the most risk-free instruments in the market. Hence, the rate of return offered by these instruments is often used as the benchmark to measure (evaluate) returns offered by other instruments.
Advantages of Bonds
Bonds have a lot of attractive features for investors. Further, bonds offer a lot of flexibility. There are many different types of bonds and hence, many different types of investors are attracted to bonds. Let us understand the important advantages that bonds offer.
Bonds are typically more secure than equity investments. As we have already seen, government bonds may even be considered to be risk-free. Due to the low-risk nature of bonds, investors looking for safer investment options and capital protection are often attracted to bonds.
As bonds are relatively low-risk instruments (generally), they often offer lower returns than the returns expected from equity. However, it is important to note that bonds generally offer much higher returns than cash equivalents (such as money market securities, etc.). It is also useful to note that in the case of bonds, the returns offered are known in advance, unlike in the case of equities normally. In the case of equity, it is difficult to assess what returns to expect. But in the case of bonds, the returns offered are declared at the time of issue of the bonds. Hence, it may be easier for bond investors to estimate their returns and plan for the future.
Different bonds carry different periods of maturity. While some bonds have a period of maturity of just 2 to 3 years, other common bonds may have periods of maturity of as long as 30 years. Due to this feature, investors with different investment horizons may be attracted to bonds. Do note that generally bonds with longer periods of maturity offer higher rates of return than bonds with shorter periods of maturity. Thus, investors looking for higher returns may choose to invest in longer term bonds (i.e. in bonds with longer periods of maturity).
Some bonds can be traded on exchanges (just like many other financial instruments) before the expiry of their period of maturity. The advantage of this feature is that it offers investors greater liquidity – at any moment, they can choose to sell off their bond and recover the money that they had invested in the bond. Further, this offers another source of profits to investors. If they sell a bond at a price higher than their purchase price, then they have made a profit on their investment. (Conversely, if they sell the bond at a price lower than their purchase price, then they might make a loss on their investment.)
Some bonds may offer very high returns. Bonds are generally considered relatively low-risk investments and accordingly, they offer lower returns than equity. However, certain high-risk bonds (for example, junk bonds) offer very high returns (as much as 50% per year and even higher). Thus, investors looking for higher returns can invest a part of their portfolio on such bonds. It is noteworthy that such bonds carry higher default risk than other bonds. Thus, investing in such bonds is typically recommended for those investors who have higher risk tolerance.
Designing a Portfolio Using Bonds
Now that you have understood what bonds are and what advantages they offer, you are ready to take a detailed look at how you can design your portfolio using bonds. Thus, we will try to get a comprehensive understanding of how to design a balanced portfolio using bonds only. Do note that experts often advise investors to invest some part of their portfolio in highly liquid cash equivalents, some part in low-risk bonds and some part in high-risk, high-return equity. However, due to the versatility of bonds, it is possible to achieve the same results using bonds only. Let us see how this can be done.
Consider an investor who wants to invest about 20% of his portfolio in highly liquid investments, 50% in relatively low-risk investments that offer some degree of capital protection and the remaining 30% in high-risk, high-return investments. (This is one example of a balanced portfolio.) Can you guess how this investor can create his portfolio using bonds only?
As we have seen, some bonds can be traded in exchanges. Such bonds offer a high degree of liquidity. Thus, this investor can invest 20% of his portfolio in low-risk bonds that can be traded in exchanges. This would comprise a very liquid investment – thus, this takes care of the investor’s plan to invest 20% of his portfolio in liquid investments. If the investor had put this money in cash equivalents (such as money market securities), he would have earned much lower returns. Hence, by investing this part of his portfolio in bonds, the investor stands to earn higher returns while also benefiting from the liquidity of these bonds.
This investor plans to allocate 50% of his portfolio in low-risk investments that offer capital protection. To achieve this, the investor can use government bonds. As we have seen, such bonds are typically considered to be almost risk-free. Thus, the investor can invest this 50% of his portfolio in government bonds. Depending on his investment horizon, the investor can choose those government bonds whose period of maturity matches the time frame that the investor has in mind. Do note that in this case, the longer the period of maturity of the bonds, the higher would be the rate of return offered by the bonds (generally). Hence, it would be advantageous for the investor to invest this part of his portfolio in bonds with longer period of maturity.
The investor can also consider investing this 50% portion of his portfolio in a variety of bonds (mix of bonds). For example, he may choose to invest 15% of his portfolio in 10 – year government bonds, 15% in 30-year government bonds and 20% in corporate bonds. Corporate bonds generally offer higher returns than government bonds. Thus, investing 20% of his portfolio (out of the 50% low-risk investment portion) in corporate bonds would enable him to earn higher returns than those offered by typical government bonds.
The investor intends to invest 30% of his portfolio in high-risk, high-return investments. For this purpose, the investor can look at high-risk bonds (for example, bonds that offer returns of more than 20% – 25% per annum). The advantage of investing in these bonds vis-à-vis investing in equity is that in the case of bonds, the rate of return available (rate of return being offered) is known in advance. On the other hand, in the case of equity, the investor would have little clue as to how much returns to expect. Thus, investing this part of the portfolio in bonds gives the investor better control over his financial future.
This is how an investor can design a balanced portfolio using bonds only. As we have seen, a balanced portfolio designed using bonds only may have certain advantages over similar portfolios designed using other instruments. This is how an investor can benefit from the versatility of bonds.
In the example that we have seen here, we have considered investing 20% of the portfolio in bonds that can be traded on exchanges (liquid investments), 50% of the portfolio in low-risk bonds (capital protection investments) and the balance 30% in high-return bonds (high-risk, high-return investments). Based on your preference, you can change these ratios to design a portfolio that matches your investment goals. For example, in case you want higher returns and are willing to take higher risk, you may invest more than 30% of your portfolio in high-return bonds (and smaller portions in liquid investments and capital investments), and so on. Similarly, you can also use bonds in conjunction with other instruments. For example, the portfolio that we considered above could also have been designed by investing 20% of the funds in cash equivalents (liquid investments), 50% of the portfolio in low-risk bonds (capital protection investments) and the balance 30% in equity (high-risk, high-return investments).
You have now understood the advantages that bonds offer and have understood how to use these useful and profitable instruments in your portfolio. So, what are you waiting for? Start designing your portfolio, achieve your investment objectives and benefit from the profitable opportunities that bonds offer.
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