Using Bonds For Passive Income
Continuing in the whole theme of finding passive income investments, let’s take a look at another asset class that belongs in the portfolio of all investors. This asset class typically performs well when stocks are performing poorly. While blue chips stocks are a winner for dividend investing, bonds offer more price stability and a guaranteed rate of return. Let’s take a look at investment grade corporate bonds.
What is a bond?
A bond is a debt security in which an individual investor lends money to an organization. Bonds have a number of unique differences from stocks. Stocks represent ownership in a company whereas a bond is an obligation of a company. Bondholders have no rights to the equity of a company but they do have a claim against the assets of a company. For example, a company that chooses to go out of business has to satisfy its obligations to its bondholders.
Bond interest is a guaranteed payment and it is made semiannually. Every 6 months an investor receives an interest payment. These payments will continue until the bond’s maturity date. The maturity date is when the bond is redeemed and the investor receives their principal back. A bond’s maturity could be as short as 1 year or as long as 30 years.
The interest rate paid depends heavily upon the credit quality of the issuer and the length of time of the bond. The interest rate environment matters as well.
What are the types of bonds?
Savings Bonds & Treasury Bonds
Savings bonds and Treasury bonds are guaranteed investment. They are bonds issued and guaranteed by the government. These are bonds in which there is extremely limited risk of default. This will only occur if the government folds or does not raise its debt ceilings to address interest payments. These bonds are virtually risk free considering that the government has not defaulted yet.
Municipal bonds are government bonds as well that are issued by state and local governments. These bonds are often used to fund highways, bridges, tunnels, roads, and other local projects. These bonds are tax advantaged since they are exempt from state taxes. Municipal bond investing bears the risk of default by the municipality.
Corporate bonds are bonds that are issued by companies. These bonds pay the highest interest rates since they are tied to the fortunes of individual company. A stable company like Berkshire Hathaway has to pay a much lower interest rate on bonds than an unstable company like Rite Aid. Corporate bonds are sold in blocks of $1,000.
Risk of bond investing
The risk of default does exist when buying a bond. A company in financial peril has a higher risk of default. For example, a bankruptcy proceeding could be used to discharge the amount of money owed to bondholders. Bondholders would have to get in line behind more senior debtholders.
Getting Passive Income From Bond Investing
Bonds are a great source of passive income because investors earn income from the activities of another entity. The income stream pays a greater return than savings accounts and certificates of deposit. Right now, investors can safely get a 4 to 5% yield on very safe bonds. Even higher rates are available for investors with greater risk appetites. Bond ETF’s and bond funds are an option for investors that would like to get access to the bond market without buying individual securities,