Investors ignore bonds at their own peril. While there is theoretically infinite growth potential in equities, and no growth-oriented investor can ignore stocks, bonds play an important role in mitigating risk and augmenting returns.
Most bonds offer a set return on investment with price fluctuations dictated by the market but, for the most part, are limited to the value of their coupon rate. Some bond or bond-like investments, such as convertibles, preferred stocks, and mezzanine loans, can offer a low-risk opportunity to capitalize on a company’s growth while also giving a reliable investment income.
Preferred stock ETFs like PFF and PGX offer investors the opportunity to buy into the preferred stock world, even if most of these investments are not usually sold on the open market.
The Total Return Fund
For more conventional, non-convertible bonds, there are a number of funds that focus on short-term, medium-term, and long-term bonds, and these can be used to bet on the dynamics between capital flows to stocks and bonds as well as a nation’s ability to repay its debts and the value of its debts going forward.Alternatively, investors can bet on the overall U.S. bond world with the Vanguard total bond fund (BND), which invests in a variety of bonds with different durations to allow investors to bet on the total bond market. The fund is near flat YTD for 2013 and trades in a very tight range, with about a 2.5% yield.
In general, bond funds go up in value as stocks go down, because investors sell the stock market and buy into the bonds. Bond funds can be used in pair-trading strategies in tandem with stock funds to capitalize on market swings, or they can be used to hedge risk. Interestingly, the beginning of 2013 saw a steep rise in stocks but did not see a comparable decline in the biggest bond funds (TLT, BND, INY, BIV, BSV). There are a number of possible reasons, but most likely this is because the drive in stock markets is not due to capital flowing into stocks from bonds, but capital coming from other sources (from abroad, from Central Banks, from commodities sell-offs, etc.)
Municipal Bonds
Like U.S. bonds, municipal bonds are an investment in a government entity and a bet on a city, state, or county’s ability to pay back debts. There are hundreds of municipal bond funds out there and thousands of municipal bonds on the market.
Municipal bonds offer a variety of yields depending on their credit ratings, but most investment-grade bonds will range between 3% and 6%. Because we live in a low-yield world and a near-deflationary macroeconomy with persistent fears of risk in equities and other investment opportunities, municipal bonds have exploded in popularity and many municipal bond funds are trading at high premiums. While a higher-yielding low-risk option, many analysts have seen greater risk in municipal bonds because of capital inflows inflating prices.
Corporate Bonds
The highest risk bonds on the market are corporate bonds, whose high risk has resulted in the nickname “junk bond” for many of these assets. The nickname has even been co-opted by SPDR for their high-yield bond ETF (JNK). These bonds usually offer yields in excess of 5%, which some very creditworthy large-cap companies offering bonds with yields below 5%.
In the search for yield, corporate bonds have become more popular in recent years, with some corporate bond funds charging very high premiums. Indexed bond funds like JNK try to track the overall corporate bond market through diversified investments, and are lower risk than specialist bond funds or buying bonds individually. JNK, for instance, has a positive total return and a price decline of 9% in total (not annualized) for the past 5 years, on top of a current dividend yield of 6.35%.
Federal Reserve’s Future Movements
Retirees like bonds because they offer a steady flow of income at low risk, and investors like them because they offer relative stability to stocks and a hedge against bear crashes like what happened in late 2008. Crashes like that are actually good things for bonds and bond funds, because the capital inflows skyrocket and prices go through the roof. For instance, TLT went up 31% in the second half of 2008 as the market plummeted.
Different types of bonds are impacted differently by the Federal Reserve’s monetary policy, but in general bonds are a good investment in deflationary times and when there is market uncertainty. However, bond funds can go down sharply in periods of equity rallies and when the Federal Reserve raises interest rates, because it lowers the value of older bonds.
Bond funds are at all-time, historically unprecedented highs and demand for bonds has been incredibly strong since 2008. Some analysts have even said that a bond bubble has been forming. This means that bonds are now a higher risk investment than they have ever been, but that has not kept investors from seeking these lucrative sources of passive income with zeal.