Broker Check

What's the Deal with Bonds?

| August 15, 2018
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People get stocks. You probably know about the S&P 500 index and that the stock of a company can be swapped for an ownership stake in its business.

But not as many people understand bonds, the *other* part of the portfolio. That's not because bonds are super complicated, because they're not. It's mainly because bonds don't receive attention like the stock market does, because quite frankly, bonds are not exciting. Less attention + less interest = less general knowledge.

Our minds are drawn to the biggest, strongest, and fastest you name it. We like our NFL games with big hits and high scores. The louder the CNBC or Bloomberg headline, the more likely we are to click. In that context, the stability of fixed income (bonds) is no match for the stock market's euphoric highs and jittery lows. As a result you don’t hear much about bonds on the evening news or at the dinner table, but you'll probably hear about the 300 point drop in the Dow Jones.

While bonds may not make the headlines, they do play a crucial role in maintaining a diversified portfolio in helping to seek protection against downside risks. And since you aren't hearing much of it from other sources, here are some takeaways when it comes to fixed income:

  • Bonds tend to be more stable and less volatile than stocks, with lower returns. A good or bad year in bonds can be like a good or bad day in stocks.
  • Bonds are debt obligations. Investors lend money to a company or a government by purchasing bonds, believing the principal (the loan amount) will be repaid plus interest (the cost of using someone else's money). With bonds you're a loaner, not an owner.
  • Aside from the interest you receive, the value of your bond can rise or fall which affects the overall return. When interest rates rise, the value of your bond holdings tend to fall and vice versa.
    • If you own a bond that pays you a 3% interest rate annually, and interest rates rise to 5%, your bond holding won't be worth as much as you paid for it if you tried to sell it. Who would want a 3% yield when 5% is the going rate?
  • Bonds are considered more conservative than stocks because there is a contractual obligation for repayment. A company does not have the same contractual obligation to pay you a dividend when you own their stock. In addition, bondholders typically have a senior claim on a company's asset in the event of bankruptcy.
  • But be careful - it's entirely possible that the borrower defaults and cannot repay bondholders. Entities that are more likely to default on payments usually offer a higher yield to entice investors to take on more risk in lending them money.
  • Typically, higher yield bonds represent higher risk and are considered lower quality obligations, as repayment is less certain.
  • During a recession, higher quality bonds tend to outperform lower quality bonds. When the economy is improving, lower quality bonds tend to outperform higher quality bonds (High yield/junk bonds (grade BB or below) are not investment grade securities and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors).
  • There are several different types of bonds. Here are a few to remember:
    • U.S. Government Bonds
      • Treasury Bills/Notes/Bonds: Debt issued by the federal government to finance its budget deficits. Backed by Uncle Sam, they're considered very conservative and high quality, offering a low yield because they're able to.
      • Municipal Bonds: Debt issued by state or local municipalities. The interest payments are tax-exempt at the federal level and possibly at the state level depending on where you live (Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. If sold prior to maturity, capital gains tax could apply).
    • Corporate Bonds
      • Investment-grade Corporate Bonds: More risky than government bonds which result in a higher yield. Issued by companies with atleast a BBB credit rating and are generally regarded as higher quality.
      • High-yield Corporate Bonds: Also known as "junk bonds"; they are usually issued by less credit-worthy companies and have a higher risk-return profile.

So there you have it. For those of you still reading, I applaud you. And for those who have moved on to something more exciting, I guess I can't be surprised ( ;

 

 

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Stock investing involves risk including loss of principal.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

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