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.
While we financial advisors need to know a lot about numbers, we often use some shortcut “rules-of-thumb” to make quick estimates. Two of those rules-of-thumb are the Rule of 72 and the Rule of 115.
The rule of 72 is a shorthand way to figure out how long it will take an investment to double in value, if one knows the annual rate of return or interest rate. The equation can also be switched around to figure out the annual rate of return if one knows how long it took for the investment to double.
It is called the rule of 72 because the doubling time is figured out by dividing the rate of return by 72. For example, an investment earning 6% per year will double in 72/6 = 12 years. An investment earning 8% will double in 72/8 = 9 years.
Flipping the equation around to determine the rate of return is done as follows. If an investment doubles in value in 10 years, the annual rate of return is 10/72 = 7.2%.
The rule of 72 is an approximation that is based on annual compounding. The true results will differ slightly. Many investment returns are based on continuous compounding which grows a bit faster than annual compounding. For situations involving continuous compounding, use 69.3 instead of 72.
The Rule of 115 is used to figure out how long it will take for an investment to triple in value. It follows the same process as the Rule of 72. If an investment earns 7% per year, it will take 115/7 = 16.4 years for the investment to triple in value. As with the Rule of 72, the Rule of 115 is an approximation. There are some practitioners that learned this as the Rule of 114. 115 slightly overestimates the time it takes for an investment to triple and 114 slightly underestimates it.
If you have REALY big aspirations… use the Rule of 144 to calculate, your investment will quadruple! 