Asset Focus: Short-Term US Bonds
In the latest in our Asset Focus series, I’m exploring short-term bonds, and how you can incorporate them into your investment portfolio.
What Are Short-Term Bonds?
A bond is a promise to repay a loan, typically taken out by a large corporation. The bond represents the borrower’s intent to repay the loan after a set period, with interest payments on the loan made every month.
A short-term bond generally matures within 4 years or less, with the loan repaid and the investor free to withdraw their initial investment.
As they are a fixed-income asset that yields a payout each month, these bonds are the perfect way to earn an income from your investments. Bonds are particularly useful for anyone who is retiring and keen to take a step back from active investing and trading.
How To Invest In Short-Term Bonds
Companies can issue bonds to fund expansion or high-value projects. Individuals can purchase these bonds if they have the capital, but you can also invest in a fund that owns a bond to take on a smaller percentage of the risk.
That being said, the least risky way to invest in bonds, is to hold the maturity. In which case you simply collect regular dividend payments and do not have to worry about the price of the bond fluctuating.
Bond funds, which might be exchange-traded funds (ETFs) or mutual funds, offer investors the chance to invest as much money as they want into an underlying portfolio of bonds, with income distributed to fund shareholders periodically, often monthly.
You can invest in an ETF through an online broker. If you already have a broker, then check their fees for ETF investments and, if necessary, explore the alternative options on the market. Here’s a list of the best ETF brokers out there right now to get you started.
What Are The Returns For Short-Term Bonds?
As the name suggests, short-term bonds mature faster than long or medium-term bonds, and as such, they pay less interest over their lifetime. This means they are less risky as there is less time for them to be exposed to credit risk and interest rate risk (see below).
Bond returns vary depending on the quality of the borrower and the risk for bondholders. You can expect the best quality bonds to pay somewhere in the region of 2 per cent(2%) annual yields in 2020.
If you’re investing through a broker, you need to take the broker’s fees into account when calculating your return on investment.
What Are The Risks?
There are 2 major risk factors to consider when investing in bonds. Interest rate risk and credit risk.
Interest Rate Risk
This is where the price bonds are bought and sold for fluctuate based on interest rates set buy the Federal Reserve. When Federal rate go down, bonds with a higher yield look more attractive to investors, and so the price goes up.
Conversely, when interest rates rise, bond prices fall as investors are willing to pay less for the added risk of investing with a corporation rather than in US Government bonds.
Interest rate risk is low on a short-term bond, as the reduced amount of time that you hold the asset for means that interest rates are unlikely to drop significantly.
This is simply the risk that the bond issuer might fail to make payments, or fail to pay back bondholders. Typically, default rates on US corporate bonds are low at around 2.25 per cent (2.25%).
Although bonds are mostly seen as a low risk option for income-hungry investors, as with any investment there is a degree of risk; if the corporate entity that is holding the bond collapses, for example, then you could lose all your money.
Conclusion And Resources
Overall, short-term bonds are definitely part of the solution for investors seeking income as part of a diversified investment portfolio, particularly if you’re eager to earn a monthly income from your investments.
If you want to find out more about investing in these bonds, then check out these resources:
To learn more about different asset classes, and stay up to date on the latest financial information, keep reading the Garnaco blog, where I share my investment knowledge and expertise. You can access the entire Asset Focus Series here.