While CD are issued by banks, bonds can be offered by businesses, all levels of governments, and many other types of organizations and individuals. The bond market is actually larger than the stock market at a commanding $119 Trillion in outstanding debt world wide as of 2021. Economists and investors use the performance of the bond market as one of the indicators for the health of an economy. This vast asset class has many benefits to the economy, but let’s discuss how bonds make you money!
What are Bonds?
Bonds are part of an asset class called “fixed-income”. This generally means that in exchange for you loaning your money to an entity, you will received a fixed payment to compensate you for the loan. At the end of the agreed upon timeframe, you will receive your initial loan amount back and keep all the payments (income) you received along the way.
What happens if you need your money before the term is up? Some bonds allow you to sell them back to the entity or to someone else in order for you to recover more or less of your initial investment. However, if you can’t find a buyer, then you are stuck with it until someone does. This is called liquidity risk since you might not be able to recover you funds when you want. If you do find a buyer, you can make or lose money if you sell before the agreed upon time is over! This is due to fluctuating interest rates.
A bond’s value is heavily tied to the current interest rates at the time the bond or loan is made. The best analogy used in the industry is a titter totter, when one side is up, the other is down. If you have a bond making a 3% rate but currently the market interest rate is 5%, then your bond’s price will be lower (or “discounted”) than what you bought it for because it is earning less interest than a similar bond that could be issued. The reverse is also true, if you are making 5% and the current market rate is 3% then your bond will be more valuable (or at a “premium”) compared to similar bonds at a lower rate.
How does this grow my passive income?
The nice thing about bonds is that it is essentially a contract. An entity needs money it doesn’t have for a project so it asks investors for capital (money) to fund the project. In return, the entity or project will produce income to pay investors back for the borrowed funds and then return your principle (lingo for initial investment of money). Since there is a time limit on the income you are receiving, they are borrowing your funds and you are borrowing the income stream without reducing your principle if held for the full term. Other assets like stocks, mutual funds, etc. have no guarantees that you will recover your principle, thus individual bonds are generally considered to have lower risk.
Bonds have different payout schedules so if you are looking for monthly income you may actually have to put some work into buying multiple bonds on different months to create monthly aggregate payouts. The more passive option is to let the professionals worry about that and buy a bond mutual fund which may payout monthly but fluctuate in the amount you receive and the value. Similar to individual stock shares that produce dividends, the more money you have invested in individual bonds, the more income you can have. Stock dividends may fluctuate as well as the price, but bond’s interest payments stick to the original contract made with you.
Why do I want this passive income stream?
Speaking specifically to individual bonds, this is about control. For those investors who enjoy looking for lower risk opportunities to build up constant, strategic income streams, bonds can play an integral role in reducing portfolio volatility. As mentioned previously, dividends can fluctuate or be canceled since there is not a contractual obligation to pay on common shares.
Bonds, for purposes of passive income, give you the investor a sense of comfort as you have a predictable amount and time frame for your income. There are also favorable tax treatments for investing in your own or other local communities. If your state is offering a bond to build or expand a city, bridge, etc., because you live there you may not be assessed any taxes! Likewise, if your personal federal tax bracket is high, you can invest in another state with low state taxes and this may significantly reduce your burden come tax time since local bonds are taxed at the state or city level and not the federal level.
Tax-free income is always a hot topic around passive income because what could be better than getting money sent to you without going to a job for it and the government doesn’t take a piece!? To be fair, you would need to work out if it’s worth it to you with a tax-equivalent yield analysis. Many of those community projects offer lower rates on their bonds than a for-profit business looking to expand operations.
Risks and Considerations
The industry uses a number of different risks to assess bonds: Interest rate risk, reinvestment risk, inflation risk, credit or default risk, liquidity risk, callable risk, and quality risk. We’ll cover default and reinvestment risk here. Default or credit risk refers to how stable the organization is and the likelihood you will get your initial investment back. The US federal government historically hasn’t defaulted (broken the bond contract by not paying) so they have a high credit rating (AAA). As credit ratings decrease from AAA, AA, A, BBB to BB, B etc. the ratings tell us how much more risky the investment is. To combat a lower rating, organizations offer higher yields to attract investors. While more income is always welcome, great care needs to be taken. High income is nice if you can get your principle back!
Reinvestment risk is present with all fixed income products. If you receive your principle back and the closest similar bond to what you previously owned is yielding less because the interest rate environment has changed, then you risk having to invest in a riskier bond or asset in order to get the same yield you were experiencing before. One strategy investors use to combat all these risks is “laddering” fixed income products. By buying different bonds, with different ratings, at different yields, and at different maturities (end dates) you diversify your income against potential defaults and against the ever changing interest rate environments.
As always, all investments are subject to some risk. While the income may be passive, making the investment decision shouldn’t be. You need the right income for your personal needs. Bonds may be a great addition to your portfolio today or in the future!
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