Typical investor

There are a wide variety of bonds available to investors, which come with varying risks and benefits. The purpose of this section is to discuss the typical bond investor without being too specific.

Unlike stocks, bonds are usually sought out by older, more conservative investors. Because of the legally guaranteed interest payments, bonds experience lower levels of risk than stocks, leading to lower rates of return. Investors seeking safe, predictable income will most likely choose debt securities over equity (stock) securities.

Remember the Rule of 100? The older an investor is, they should generally invest more in fixed-income securities like bonds. Let’s take a look at a table from the suitability section of common stock:

The Rule of 100 is a little easier to utilize with bonds. Essentially, an investor’s age matches the percentage of bonds they should include in their portfolio. Keep in mind this is a generality and doesn’t always apply. There are some very aggressive older investors that have enough assets to take higher levels of risk. An 80-year-old billionaire could afford to put a large portion of their portfolio in more volatile investments like common stock. There are also younger investors that are more risk averse (conservative). Bottom line - use the Rule of 100 as a generality, but know there are exceptions.

We’ll learn about the varying levels of risk unique types of bonds are subject to. While generally viewed as safe, there are plenty of risky bonds out there. Junk bonds, which are typically offered by unproven or financially distressed companies, offer high yields. Of course, the investor could lose a significant amount of money if a default occurs.

Interest income is the primary benefit that bonds provide. If an investor is not seeking income, they should probably invest in another asset class. The only exception is for zero coupon bonds, which pay interest only at maturity. If an investor seeks a predictable payout years later but doesn’t need income along the way, a long-term zero coupon bond could be suitable.

Bond strategies

Investors seeking bonds as a part of a long-term strategy in their portfolio may implement one of a few bond strategies. The most popular are:

• Ladders
• Barbells
• Bullets

Bond ladders
As the name may suggest, a bond ladder can be visualized as climbing up the rungs of a ladder. This type of strategy involves investing in numerous bonds with a diverse set of maturities. For example, let’s assume an investor wants to purchase $10,000 worth of bonds with varying maturities. They could end with something like this (assume each bond is $1,000 par):

• 3-year bond
• 6-year bond
• 9-year bond
• 12-year bond
• 15-year bond
• 18-year bond
• 21-year bond
• 24-year bond
• 27-year bond
• 30-year bond

By spacing the bonds out evenly (by 3 years in this example), the investor gains maturity diversification. While the longer-term bonds will be subject to high levels of interest rate and inflation risk, the shorter-term bonds won’t be as exposed. Because of the risk factor, the longer-term bonds will likely have higher yields than the shorter-term bonds. ​

Bond investors utilizing this type of strategy tend to maintain a “revolving door” approach. When a bond matures, the proceeds are reinvested back into a long-term bond. Using the example above, let’s assume 3 years pass and the shortest-term bond matures. When this occurs, those proceeds could be used to purchase a new issue 30-year bond. That’s why this strategy is referred to as a ladder. As soon as one rung is passed (short-term bond matures), another rung is grabbed (proceeds invested in a long-term bond).

Bond barbells
Visualize a barbell you would lift in the gym. There are two ends with weights, with a skinny bar in the middle. This type of bond strategy makes reference to a gym barbell. The investor places their money into short-term bonds and long-term bonds, but no intermediate bonds. For example, let’s again assume an investor wants to purchase $10,000 worth of bonds with varying maturities. They could end with something like this (assume each bond is $1,000 par):

• 1-year bond
• 2-year bond
• 3-year bond
• 4-year bond
• 5-year bond
• 26-year bond
• 27-year bond
• 28-year bond
• 29-year bond
• 30-year bond

By investing in a bond portfolio in this manner, it could be argued an investor is gaining the benefits of both types of bonds (short and long term). The short-term bonds provide more liquidity with less interest rate & inflation risk. When a short-term bond matures, the investor can make a strategic choice. If interest rates have risen, they can purchase a long-term bond and lock in a high yield for a long period of time. If interest rates have declined, they can invest in another short-term security and wait for interest rates to rise.

The long-term bonds provide higher rates of return (yield), although they involve higher levels of risk. However, the risk is being balanced out by the other half of the portfolio.

Bond bullets
A bond bullet strategy makes reference to a bullseye. Investors utilizing this plan of action typically have a specific target date in the future in which they require a large payout.

For example, let’s assume an investor is saving for a dream home over a 10-year period. Every year, the investor purchases $100,000 of bonds, all of which will mature at that 10-year mark. In the first year, the investor purchases $100,000 of 10-year bonds. The next year, the investor purchases $100,000 of 9-year bonds. The following year, the investor purchases $100,000 of 8-year bonds. And so on.

By the time the investor reaches the 10-year mark, they’ve purchased $1 million of bonds, all of which will mature that year.