Investing 101: An Intro to Bonds
As much as I wish I could introduce you to the basics of Agent 007 impersonators, I am actually talking about the kinds of bonds that make YOU money.
Everyone is aware of the sex appeal associated with stocks, but bonds unfortunately lack the same appeal especially when the stock market is in full bull-mode and there is far more money to be made in equities. People really only pay attention to bonds when their portfolios are at the risk of drastic losses, but if they made the effort to diversify in bonds in the first place they would have no reason to dread market fluctuations.
While bonds have never been my forte, I have made a conscious effort in recent months to learn about and emphasize the importance of using bonds to diversify your portfolio. In the coming weeks we'll discuss more about bonds, but for the moment this should provide you with the bare bones basics for understanding this crazy world of bonds...no, James'.
What exactly ARE bonds?
Just like people can borrow money from a bank, companies and governments also need to borrow money in order to expand their programs and into new markets. Unfortunately for large companies and municipalities, they need to borrow far more money for advanced projects than banks and financial institutions have on hand to offer. The solution, therefore, is to raise money from the public by issuing bonds (or other debt instruments). Collectively, thousands of investors lend the public a portion of the debt instruments needed to complete the loan, and in return the company or government will pay interest on the bonds issued to the public. Ultimately, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).
How do the interest payments work?
Interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back if you hold the security until maturity.
As an example: let's say that you purchase a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years.
Because most bonds pay interest semi-annually, you'll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you'll get your $1,000 back.
How is "debt" different than "equity"?
Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits.
By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well - he or she is entitled only to the principal plus interest. Ultimately, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.
Why do investors even bother with bonds if they don't have large returns?
It's an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn't mean you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Take two situations where this may be true: 1) Retirement - The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills. 2) Shorter time horizons - Say a young executive is planning to go back for an MBA in three years. It's true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment. These two examples are clear cut, and they don't represent all investors. Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout your life. For example, in your 20s and 30s a majority of wealth should be in equities. In your 40s and 50s the percentages shift out of stocks into bonds until retirement, when a majority of your investments should be in the form of debt securities.
(For more details on bonds, you can read more articles on Investopedia)