Question

Why are government bonds attractive as part of a balanced investment portfolio? How does the tax treatment of certain types of government bonds affect their attractiveness to certain types of investors? What are the potential benefits / risks of investing in the following types of bonds in comparison to "standard" US Treasury debt of the 1 - 10 year variety (a) long dated zero coupon bonds (b) Bonds issued by a state or municipality with less than perfect credit (c) debt issued by a government agency like GNMA (d) CDO's which hold debt secured by such things as GNMA mortgages (e) inflation linked bonds?

Answer 1

What is a Bond?

A bond is a debt instrument.Bonds are used by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Owners of bonds are debt holders, or creditors, of the issuer.Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount).

The Benefits of a Bond Portfolio

Bond portfolios are usually preffered than stock portfolios when it comes to popularity .Properly-constructed bond portfolios can provide income, total return, diversify other asset classes, and be as risky or safe as the designer desires. The fixed-income world is as diverse and exotic as the stock market.

• Bonds are a vital component of a well-balanced portfolio.
• Bonds produce higher returns than bank accounts, but risks remain relatively low for a diversified bond portfolio.
• Bonds in general, and government bonds in particular, provide diversification to stock portfolios and reduce losses.
• Bond ETFs are an easy way for investors to gain access to the benefits of a bond portfolio.

There are reasons why both individual and institutional investors require bonds as part of a balanced portfolio. The main reason is that coupon income is only one component of the bond portfolio's total return. Also, the low correlation of bonds as an asset class with the equity asset classes provides some stability through diversification.

1. Total Return

While many investments provide some form of income, bonds tend to offer the highest and most reliable cash streams. Even at times when prevailing rates are low, there are still plenty of options (such as high-yield bonds or emerging market debt) that investors can use to construct a portfolio that will meet their income needs.A bond portfolio's total return is the overall change in its value during a specified time interval, including income and capital appreciation or depreciation. Market value fluctuations, and ultimately risk characteristics, are affected by interest rates as measured by the yield curve. The interest rate environment is dynamic. As a result, the source of the return is not only the prevailing rate on a static yield curve. It also includes price changes caused by fluctuating interest rates over the time period.

2.Diversification

As an asset class, bonds help diversify the overall portfolio because of their low correlation to other asset classes. The lonely bond portfolio always shines brightest when equity markets slump. While the correlations vary widely over time, bonds are not highly correlated with any other asset classes. Even in the simplest diversified portfolio, bonds can reduce volatility due to their low or negative correlation with stocks. The more that investors learn about diversification, the more likely they are to add bonds to their portfolios.

3.Making Bonds Easy With ETFs

Investors do not have to become bond geeks or learn how to be bond traders to buy bond ETFs. Bond ETFs can be purchased just like stocks and give investors instant access to ready-made bond portfolios. Aggregate bond ETFs provide access to the entire investment-grade bond market. They are ideal for investors who are looking for something relatively low-risk with a higher return than the money market. However, those who want to safeguard their stock holdings are better off with government bond ETFs. Government bonds often go up in price when stock prices fall, so they provide more protection.

4.The Bottom Line

Like Tonto and Robin, bonds have typically been viewed as less-glamorous sidekicks. Many investors think that bonds are boring and complicated, but ETFs make them easy. There are a lot of interesting options in the bond market too. Buying U.S. government bonds during a bear market for stocks can be far more profitable and exciting than waiting around in cash. When investors expect a bear market to end, junk bonds are often a higher reward and lower risk choice than stocks. Finally, a highly diversified bond portfolio is an easy way to make a little more money than cash with a little more risk.