Stocks and Bonds… wait… What are Bonds Anyway?

By Holly Franklin

How many times have you heard the term diversification in relation to investing and you just nodded your head without fully understanding? What about when people talk about stocks and bonds? Stocks are relatively easy to understand, but bonds? They can be a little more complex… there’s a reason for the Wall Street saying, “The smart money’s in bonds.”  

So, what are bonds? 

Well, in short (for our purposes), a bond is a lending contract between an investor (you) and a company (the bond issuer). If you like, you can think of a bond as a loan that you’ve given, and the bond as an IOU. For instance, when you buy a house,  typically, you’ll get a mortgage from the bank and you agree to pay the bank back all the money you borrowed to buy the house, plus interest. If you look at your mortgage statement, you’ll see that your monthly payment is split between interest and principal. The interest is the fee you’re paying the bank to borrow their money, and principal is what you actually borrowed. Bonds are similar in that the issuing company offers you a coupon rate or “fee” to borrow your money for a certain period.  Most of the time, the fee is paid every six months, but it can be monthly, annually, or even not at all until the bond actually matures.

Example: ABC Company wants to expand their offices. Instead of taking out a loan from the bank, they issue bonds to investors. You happen to think that ABC Company is going to remain in business throughout this expansion, and you feel comfortable lending them your money. This is when you might buy a bond.  For each bond you buy, you lend $1000 for ten-years to the company.  The bonds are issued with a 3.6% coupon. This means that every year, ABC Company will pay you $36. After 10 years is up, the bond matures, ABC redeems the bond, and gives you back your $1000 dollars. So, for your initial investment of $1000, you have made a profit of $360. There are many other factors to consider, but this is a very simple example. 

Bonds may offer a low risk opportunity for income generation while offering some portfolio diversification. Usually (not always), when the stock market isn’t doing well, the bond market seems to pick up the slack. Having both equity positions and bonds in your portfolio helps to even things out when the stock market might not be doing so well. Bonds also typically offer some capital preservation opportunity. If you’re not needing the money that you invested any time soon, you can keep a few low risk/high rated bonds and put yourself into a “set it and forget it” mindset; while getting income from your coupon payments. 

Okay… then why doesn’t everyone invest in bonds if it’s that easy?

As with any investment, there are still some risks with owning bonds. The most common one is known as interest rate risk. When the Federal Reserve changes interest rates on lending, it affects bond prices. When rates rise, bond prices tend to fall. What does this mean for you? If the interest rates are higher today than what they were when you bought your bond and you suddenly needed your money back from your bond before the ten years was up, you might have a hard time selling it for the same price you bought it at. Why would another investor pay you full price for your bond when they can buy a brand-new bond at a better rate? On the other hand, lower interest rates may make your bond more appealing to other investors, resulting in an increase in price in your account. 

Similarly, bonds may have liquidity risk. If you’re not willing to take the lower price that you’re offered, then you might be stuck with the bond until it matures. Another risk associated with bonds is credit risk. Just as an individual can default on a mortgage, a company can default on their bond. Generally, this requires that the company file for bankruptcy for protection – and to help investors avoid that, Moody’s, S&P, Fitch, and other credit rating companies provide investors with information about the credit-worthiness of companies and their bonds. These are called credit ratings. A bond may be rated as  investment grade, speculative, or high yield (you may have heard the term “junk bonds”). These ratings can help you determine how much credit risk you’re willing to take on.  

Okay, I’m convinced! How do I invest in bonds?

There are a few different ways! You could invest on your own if you wanted to. You would need to call a broker and ask them to buy the bond “for” you. If you go this route, the broker will likely charge a markup for their service. Alternatively, you can go online and buy a bond yourself. This might seem easy, but without the knowledge of how to tell which bonds are worth their price, you may be taking a bigger risk than necessary. Third, you could have a conversation with your financial advisor about the amount you want to invest, your risk tolerance, and any other specifications you may have. They will then decide which bonds are right for your portfolio and buy them for you.

Overall, when making any investment or planning decisions, it is best to do extensive research, or find a financial professional that is knowledgeable in the specific strategies you want to use to build and diversify your portfolio.

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