Investing for FIRE: Bonds Edition | What are Bonds? Generating Regular Income through the Pros and Cons of Bond Investing
In my previous post, I introduced "Stock Investing" as one of the ways to generate immediate cash flow.
Today, I want to introduce another method aimed at the same goal: regular cash income.
That method is "Bond Investing."
By purchasing bonds, you can generally receive interest payments higher than those of a bank deposit, thereby earning passive income in the form of interest.
For those seeking financial independence, bond investing is a tool well worth considering for your portfolio.
In this article, I will explain the overview, characteristics, and the pros and cons of bond investing.
What is Bond Investing? 3 Key Characteristics to Master
Bonds are securities issued by governments or corporations to raise funds. The issuer promises to pay investors regular interest (coupons) and return the principal at the "maturity date."
Generally, because interest is paid regularly, bonds are suited for those who prefer stable asset management.
The three main characteristics are:
1. Stable Returns
2. Risk Diversification
3. Prices Influenced Primarily by Interest Rate Trends
1. Stable Returns
One of the charms of bonds is the regular payment of interest (coupons).
Fixed-rate bonds, in particular, provide a set amount of interest periodically, making them ideal for investors seeking stability.
2. Risk Diversification
Bonds have different risk profiles than stocks, helping to diversify your portfolio.
While the relationship between bonds and stocks is often called an "inverse correlation," this depends on the situation. For example, when interest rates fall, bond prices tend to rise.
While this may also cause funds to flow into the stock market, it is important to note that this correlation does not always hold true.
3. Prices Influenced Primarily by Interest Rate Trends
Bond prices and interest rates move in opposite directions.
If market interest rates rise, bond prices fall. If interest rates fall, bond prices rise.
Because they are so closely linked, monitoring market rate trends is essential.
Pros of Bond Investing: Stability for Future Financial Planning
The benefits of bond investing include:
1. Predictability for Financial Planning
2. Principal Protection (provided the issuer remains solvent)
3. Opportunity for Capital Gains through Resale
The appeal of this business is that it provides regular, stable income, which means stable cash flow.
The three benefits are explained below.
1. Predictability for Financial Planning
Bond coupons provide a predictable cash flow, allowing you to plan your future finances.
Furthermore, since bonds have fixed maturity dates, they are excellent for systematic management.
For example, building a bond portfolio to secure living expenses after retirement is a strong strategic option.
2. Principal Protection (provided the issuer remains solvent)
Fundamentally, the issuer (government or corporation) promises to return the principal at maturity.
As long as the issuer does not go bankrupt, you can recover your initial investment.
3. Opportunity for Capital Gains through Resale
Bonds are not just for holding until maturity; you can sell them on the market.
Prices fluctuate based on interest rates and the issuer's credit status.
This allows you to make a profit from the difference between the purchase price and the selling price.
If interest rates fall, the value of existing bonds (with higher coupon rates) increases, giving you a chance to sell at a profit.
Conversely, if rates rise, you may face a loss if you sell early.
In this way, bonds can generate profits not only through "interest income" (income gains) but also through "price difference gains" (capital gains).
(I have summarized income gains and capital gains in the following article, so please refer to it.)
What you need to know about income gains and capital gains to achieve FIRE – Julius Co., Ltd.
Cons of Bond Investing: Understanding the 4 Major Risks
While bonds facilitate stable management, you must keep these four risks in mind:
1. Price Volatility Risk: Prices fluctuate with market interest rates.
2. Credit (Default) Risk: The risk that the issuer cannot pay interest or return the principal.
3. Liquidity Risk: The risk of not being able to find a buyer when you want to sell.
4. Currency Risk: For foreign bonds, fluctuations in exchange rates can lead to losses in your home currency.
In these days of drastic fluctuations in stock prices and exchange rates, there are many aspects that are difficult to predict, so it is necessary to take these risks into consideration when deciding on the company to invest in, the timing, and the amount.
1. Price Volatility Risk
The prices of bonds fluctuate depending on market interest rates.
If you can sell your bonds when the price rises, you will make a profit, but if you sell them when the price falls, you may incur a loss.
2. Credit (Default) Risk
This refers to the possibility that a bond issuer will be unable to fulfill its obligations, such as paying interest and repaying principal.
Even if you lend money to a country, organization, or company through bond investment, if they go bankrupt you will not receive interest payments and there is a possibility that you will not be able to get the money you lent back.
3. Liquidity Risk
Bonds can be sold on the market, but in reality, it is difficult to sell them if there is no demand.
There is a liquidity risk that even if you want to sell, you will not be able to sell because there are no buyers.
4. Currency Risk
Foreign bonds involving foreign currencies are affected by exchange rates.
There is a possibility of losses due to exchange rate fluctuations.
Summary
I personally include U.S. Corporate Bonds and U.S. Bond ETFs in my portfolio.
The two main benefits I feel in my daily management are:
• Regular Cash Income
• Portfolio Diversification
As I often mention on this blog, passive income is essential for financial independence (owning assets that generate cash flow so you don't have to work).
In that sense, the regular income from bond investing is a huge help.
It also serves as a great way to build foreign currency assets.
Regarding the inverse correlation with stocks, I find it serves as a "psychological cushion" when stock prices drop, though it isn't perfect.
One gap I noticed after I started holding them: the volatility is higher than I expected.
Especially since I hold long-term bonds, they are highly sensitive to interest rate changes.
For those who dislike price fluctuations, this is a crucial point to keep in mind.
About the Author Kenji Kamioka
CEO, Julius Inc. / FIRE Practitioner
Kenji Kamioka is a former IT executive who spent 30 years in the corporate world, with over 10 years working across Asia. His life changed when he read Rich Dad Poor Dad.
Realizing the trap of the "rat race," he started building assets in real estate and stocks while still working. It took him 10 years, but he successfully achieved Financial Freedom and graduated from the salaryman life.
He established his own asset management company to optimize tax efficiency and now dedicates his time to teaching others how to escape the corporate cage.
His advice is not theoretical but based on the gritty reality of achieving FIRE.AFP (Certified by the Japan Association for Financial Planners), Licensed Real Estate Transaction Specialist
Book
❶『令和のサラリーマンの為のFIREのススメ』(Amazon電子書籍）
❷『FIRE Recommendation for Office Employee』(Amazon Kindle）
