Last week, I discussed two strategies for generating income in this tough market environment. While selling covered calls and naked puts is a conservative strategy, some investors prefer more of a “set it and forget it” approach.
Fortunately, there’s a simple solution.
Bonds.
You may have never invested in a bond, but they’re actually easier to understand than you might think.
When you buy stock, you own a piece of the business. But when you buy a bond, you are a creditor to the business. As anyone who’s ever owned a business knows, creditors get paid before owners. Otherwise, the creditors take your business.
A bond is a contract between a borrower (the company) and a lender (the bondholder). The company must pay bondholders a predetermined amount of interest on specific dates and then pay the loan off in full on the maturity date. No ifs, ands, or buts. There is no wiggle room. If the company does not live up to those obligations, it is in default, and bankruptcy proceedings start.
If a stock falls in price, you have to pray to the investing gods that it will come back up and make you whole.
If a bond falls in price, it doesn’t matter, because the company will pay $1,000 per bond on the bond’s maturity date, no matter what. If it doesn’t, it’s in default.
Bonds are incredibly safe. Investment-grade bonds default at a minuscule rate – way less than 1%. Non-investment-grade bonds, also known as high-yield or junk bonds, default around 4% of the time. However, the overwhelming majority of those defaults are from the lowest-graded bonds, rated CCC or lower. A bond with a grade of B- or higher has a very low chance of default.
Lastly, my favorite feature about bonds is that you know exactly how much you are going to make over a specified period of time. You’ll never have that kind of certainty with a stock.
Here’s what I mean.
Let’s say you buy a bond at a discount for $950. The bond matures in two years and pays a coupon of 5%. The coupon is based on the $1,000 par value, so the bond will pay $50 per year in two installments of $25 each.
Because you bought the bond at $950 instead of $1,000, your yield is 5.3%. Additionally, you’ll earn a $50 capital gain because you bought the bond for $950 and it will mature at $1,000.
In total, you’ll have made $100 in interest and $50 in capital gains for a total return of 15.8%, or 7.9% per year. Even better, you’ll know what that expected gain is before you ever hit the buy button on your broker’s website.
Bonds provide both income and security, with no exposure to the stock market’s volatility.
If the wild swings of the stock market are causing you stress, consider moving some money into individual bonds.