Like 007: Successful Bond Selection

Bonds are one of the most essential investments available for those who hope to live off the money generated from their portfolio. The art of good income investment is about putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that generate the highest possible annual income, at the lowest possible risk. The volatility in 2018 is a clear example of why portfolio diversification is a wise move. You really shouldn’t be keeping all your eggs in one basket.

If you're more risk-averse and can't bear the thought of losing money, bonds might be a more suitable investment for you than stocks. Of course, the safest investment you'll come across is none other than cash in the bank, but bonds typically pay better when it comes to interest.

Bonds are a great choice if you're near retirement or if you are already retired. At that point in your life, you may not have the time to ride out the stock market downturns, in which case bonds are a safer place for your money. Most people are advised to shift away from stocks and move into bonds as they get older, and this isn't terrible advice, provided you don't make the mistake of dumping your stocks entirely in retirement.

Benefits of Investing in Bonds

One advantage of putting bonds in your portfolio is that they're a relatively safe investment. Bond values don't tend to fluctuate as much as stock prices, so they're less likely to keep you up worrying at night.

Another benefit of bonds is that they offer a predictable income stream. Because bonds pay a fixed amount of interest twice a year, you can generally rely on that money to come in as expected. Municipal and Treasury bonds offer the additional benefit of paying tax-exempt interest to varying degrees.

Furthermore, some investors prefer municipal bonds because these bonds offer the chance to invest in communities. When you invest in a municipal bond, you might help to improve a local school system, build a hospital, or develop a public garden. There’s a social angle, combined with the potential for a completely tax-free interest income, which is why some investors forgo the higher interest rates of corporate bonds and invest in municipal bonds instead. If these terms are new to you, you can refer to my first power read, Introduction to Bonds, where I explain these various terms.

Drawbacks of Investing in Bonds

Though there are plenty of good reasons to invest in bonds, there are some disadvantages you should keep in mind. Much like other types of investments, bonds are also subject to risks such as call and prepayment risk, credit risk, re-investment risk, exchange rate risk, default risk, inflation risk, sovereign risk, and yield curve risk. The key risks with bonds however, are the interest risk and default risk.

Since bonds are a relatively long-term investment, you'll face what's called interest-rate risk once you buy them. For instance, what happens if you buy a 10-year bond paying 3% interest and a month later, that same issuer offers bonds at 4% interest? Suddenly, your bond drops in value, and if you hold it, you'll lose out on potential earnings by getting stuck with that lower rate.