The Ultimate Guide to Financial Freedom
The phrase “do not put all your eggs in one basket” could not be any truer for investments. A profitable investment portfolio is diversified.
While asset classes like stocks provide a high rate of return, they are highly volatile and subject to price changes due to economic cycles. Bonds, on the other hand, may have a lower rate of return, but they are less volatile, safe, and carry predictable income.
Most people understand how to choose the best stocks, such as looking at the trends in earnings growth and the price-earnings ratio. But few people know how to pick the best bonds.
How to Choose the Best Bonds
As much as bonds are low risk and less volatile, you could lose your money if you invest with an issuer who eventually defaults.
1. Do Your Research
A bond is like a loan that you offer to a company or government institution. If the entity you are loaning cash to is not financially stable, they could fail to pay. And this means losing your initial investment. Do your homework by checking the creditworthiness of the company.
Avoid junk bonds. They may have an attractive interest rate, but their risk of default is also high. The best bonds are those branded ‘investment grade’. They have a lower risk of default.
2. Do the Math
Most people overlook the cost of the investment. If there are fees or commissions you will pay a broker or financial manager and taxes, will they exceed your returns? Will you make as much as you had hoped for?
Check that the quality of the bond can help you sell at a profit. Bond prices in the secondary market fluctuate in price depending on factors like interest rates, credit quality, and economic conditions. If the price rises above the face value, it is selling at a premium and you can make a profit.
3. Check the Interest Rate
Bonds can either carry a fixed or floating interest rate or one that is payable at maturity, also known as zero-coupon bonds. Your choice will depend on your cash flow needs
With fixed-rate bonds, the interest rate is established during the issuing of the bond, and interest payments are paid periodically. With floating rate bonds, the rate changes in line with a short-term benchmark rate like LIBOR (London Interbank Offered Rate). Zero-coupon bonds will only pay the interest at maturity of the bond.
4. Individual Bonds vs Bond ETFs
Bond ETFs (exchange-traded fund) contain bonds of various forms, such as government and corporate bonds. Unlike individual bonds, they do not have a fixed maturity rate. Instead, their maturity is the weighted average of the maturities of the bonds in the portfolio.
Unlike individual bonds, bond ETFs pay their coupons more regularly, making them suitable for investors in need of cash flow. This is because they hold different issues at once with different coupon payment dates. Bond ETFs are also the best choice for day traders. They resemble equities and day traders can trade them on an exchange like stocks. They are also highly liquid.
Investment is one of the best ways to achieve financial freedom, but only if you are wise about it. Diversify your portfolio with high-quality bonds that meet your investment and cash flow needs. When you have different asset classes of different in your portfolio, you mitigate risk. And this increases your returns.