What are the advantages of holding bonds?

We have seen in this post what bonds are. However have you asked yourself what are the advantages of holding bonds. We are going to have a look at the different uses of bonds for the average investor.

1. Safety investment

One of the most important uses of bonds for the average investor especially in this recession is to secure your portfolio. Investors who anticipates a bear market, turmoil in the stock market or a recession  might not want or have the courage to watch their portfolio’s value fluctuate widely. As a result in anticipation they will want to sell their investment and flee to the safest investment. Some will invest in treasury bonds, treasury bills, high quality corporate bond or money market mutual funds. After the events the investors can sell these safe assets and then reconstitute their portfolio. 

2. To maintain the value of the portfolio

The first use of bonds for the average investor is to maintain the value of the portfolio. Most bonds can be said to be quite safe especially if you invest in government bonds and investment grade corporate bonds. Because bonds are issued at a discount and then redeemed at face value the investor is certain that he will obtain more than he invested initially. Furthermore some bonds will pay coupons twice a year. So even if the return on bonds are small, the investor is assured to end up with more that he started with. If you invest in treasury inflation protected securities then your principal will be adjusted so that you will not be hurt by inflation. thus your return will always be greater than inflation.

3. Diversification

Diversification a strategy whereby you invest in a range of securities and in various sectors so that they will not be affected equally. If your portfolio is equally diversified it is possible that some of them will increase in value while while some of them will decrease in value thereby offsetting each other. Bonds are the best asset to hedge against stocks. As you the value of stocks increases and decreases while that of bonds will remain the same. Hence when the stock market is down the presence of bonds will reduces the loss of value of the portfolio. Now when the stock market is up the percentage of stocks in the portfolio increases as a result to keep the value of bonds in the portfolio constant you will have to rebalance. You will thus sell stocks to buy bonds. This will ensure that you lock the gain in stock market by buying bonds.

4. Fixed income generation

Some people, especially retirees need a regular source of income. Because bonds pay regular coupon every six months a portfolio that has a sufficient number of bonds in it will provide income to the retiree on a regular basis. Stocks on the other hand pay dividends but it is not compulsory for companies to pay dividends so an investors that have stocks in his portfolio is not certain of receiving dividends on a regular basis. However since on the long run the stock market rises then the investor is sure that the value of his stocks will increase with time.

As you can see it is very important to have a certain percentage of you money invested in bonds for the presence of bonds will help to stabilise your portfolio. 20 % for the aggressive investor up to 40 % for the prudent investor is an appropriate allocation. However make sure that your bonds are sufficiently diversified ranging from safe government bonds to slightly yieldy corporate bonds. If you are adventurous you can invest in municipal bonds.

Strategies for the successful investor part 6 :Index the market

Like i said in my previous post trying to outperform the market is a waste of time. The way to go is through index fund or mutual fund since it is rare that someone can outperform the market consistently.

So what would you do if you are investing in traditional assets like stocks and bonds. You have to try to index the market.

What you should do is to invest in companies that are of different sectors of the economy. You will thus select a number of different companies to invest in. What you would do is to add the market capitalisations of all the companies that you want to invest in.

Then if you want to invest in a company X you will have to invest  money in company x acording to the equation below

Money invested = (Market capitalisation of x/total market capitalisation) * money that needs to be invested

You might want to create a spreadsheet to help you determine how much to invest in each company.

Now the indexing will not be similar to a professional index fund but it will approach it if you

1. Choose a large number of sectors of the economy to invest in such the companies you invest in will make your portfolio representative of the economy.

2. in each sector of the economy that you invest in you select a few companies that will be representative of that economy. You will thus invest in a series of mega cap, large cap and small cap companies.

Similarly you will invest in bonds such that you will invest in securities with a wide range of maturities and issuers. Hence your bond portfolio will be spread across municipal bonds, corporate bonds and government bonds. You will also have to invest in the money market and capital market bonds so as to spreads your exposure to different maturities of bonds.

What are treasury bonds ?

A treasury bond is a government security that has a maturity that ranges from 10 years to 30 years. It is thus a security that is traded in the capital market.

Like the treasury note it is issued at a discount. It also pays a coupon every six months according to a coupon rate. This security is mostly held by institutions that have long term liabilities like pension funds, long term insurers, etc. 

Government securities: Bills, notes and bonds

Government securities are debt instruments that are issued by central banks with the aim of raising funds to finance government deficits. They can also be issued as a result of monetary policy where they are used to drain liquid. Although government usually prefer to use longer maturity to finance deficits while central banks usually like short-term maturity securities in monetary policy.

Types of government securities

There are four main types of securities that government issues

1. Treasury bills 

2. Treasury notes

3. Treasury bonds

4. Treasury inflation protected securities (Tips)

These securities given the fact that they are issued by the government they are considered to be quite safe. However you should be aware that not all government securities are safe. Investors should remember examples such as Argentina defaulting on its bonds or Dubai trying to dodge  out of its obligations by asserting that legally the bonds are not issued by the government but by a separate entity control by the government.  

These government securities are also highly liquid. In fact government securities are  the most traded of all securities. This is because by law banks, insurers and other financial institutions are required to hold a certain percentage of safe assets on their balance sheets. Hence a lot of these institutions hold government securities to reduce risk in their portfolio.

The increased liquidity comes from the fact that these institutions needs to have access to their funds at short notice. However when they do not need their money they need to invest it in a safe asset that they can sell easily. Hence this add to the increased liquidity of the government securities.

These securities can be obtained from two ways. Either over the counter at central banks and with financial institutions or though a system of auction at which financial institutions bid for them. we have already seen this system in the post on treasury bills.