Investing 101 – Bond Basics
Stocks seem to get all the attention with daily reports of what happened in the stock market. Bonds by comparison are the quiet, introverted sidekick to stocks. Nobody ever brags about their latest bond investment at a cocktail party. Nonetheless, bonds are an essential part of most portfolios and tend to become more so as we get older. Let’s take 5 minutes to understand bonds.
Bond are loans that have been “securitized”, meaning that the face amount of the loan has been divided into equal-sized parts, typically worth $1,000 or $5,000. The equal sized parts are called bond certificates
, which can then be bought and sold easily in the bond markets. Big issuers of bonds are corporations and governments. Borrowing money by selling bonds can be cheaper than going to a bank, particularly if the issuer wants to borrow a large sum and then pay it back over a long period of time, such as 20-30 years. Bonds issued by the U.S. Government are called Treasury bonds, bills or notes
. Bonds issued by state and local governments are called municipal bonds
, while bonds issued by companies are called corporate bonds
Bond Investors make money from the cash flow created by the bond issuer repaying the loan. Bonds are usually structured so that the owner of a bond (the Bondholder
) receives interest payments at regular intervals. The bondholder is repaid their initial investment in the bond, along with the final interest payment, at the loan maturity date.
Bonds are attractive to many investors because they provide a regular stream of income. The amount of income a bond holder will receive over the life of the bond is known the day it’s purchased. That knowledge means that bond values do not fluctuate nearly as much as stock prices. Bond values do fluctuate some, which is primarily caused by changes in the prevailing interest rates in the economy and the ability of the bond issuer to make bond payments.
Bonds are an important part of investment portfolios because they typically act the opposite of stocks. Treasury bonds in particular will rise in value during times of economic stress, as people flee a falling stock market for the safe predictable return bonds offer. Bonds are also important because they provide cash flow to people taking regular draws from their portfolios to pay living expenses.
If bonds are so much safer than stocks, why not invest 100% in bonds? Investing entirely in bonds is risky for the long-term because of the threat of inflation. Inflation causes the cash flow from a bond to become less valuable over time. And, although bondholders still get the principal they invested when the bond matures, that initial investment just doesn’t buy as much as it did 20 years ago. Stocks on the other hand have a history of outpacing inflation over the long-term. This is why even the most conservative portfolio is better-off containing at least some allocation to stocks, as a hedge against inflation.
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