Pity the bond. It always gets second billing. We talk about “stocks and bonds,” never bonds and stocks. It makes bonds sound like a sidekick. Batman and Robin, hamburger and fries, stocks and bonds.
But in reality, bonds are a legit star of the financial show. The bond market in the U.S. is valued at $40 trillion, twice the size of the domestic stock market. Here’s an introduction to bonds to help you decide if they should be in your portfolio.
(Spoiler alert: Bonds should be in your portfolio.)
What IS a bond? A bond is a loan. When a large company or a government needs to raise capital, it issues bonds. Bond buyers are essentially lending the issuer money in exchange for interest. That interest, or “coupon,” is paid at a set rate over a predetermined time period. The date when the principal must be repaid is called the maturity date.
So, if you buy a bond with a 10-year maturity for $1,000 at a 7% coupon, you would receive $70 per year for a decade, at which time you would get back your $1,000.
Why don’t the companies just get a bank loan? Because they often need more than financial institutions can lend.
Who issues bonds? There are basically three types of bonds:
- Treasury -- issued by the U.S. government to fund government operations.
- Municipal -- issued by local governments, typically for capital projects like sewer systems, road projects or, you know, sports stadiums for billionaires.
- Corporate – issued by companies to fund various initiatives.
The interest rate on a bond is significantly influenced by the reliability of the issuer. The more secure the issuer, the lower the rate. Thus, Treasuries (very secure) pay the lowest rates, corporate bonds the highest. The rate on a corporate bond depends, in part, on the company’s credit rating. The shakier its situation, the higher rate it must offer to lure bond buyers.
How do I calculate the return on a bond? Wow. Knew that was coming. Many new investors shy away from bonds because the relationship between a bond’s price and its yield can seem confusing. But we can do hard things, so here we go:
The first thing to know is that bonds are publically traded, so a bond’s price can change daily, just likes a stock’s. Bond prices are greatly influenced by overall interest rates. As rates go up, bond prices fall.
A bond’s yield can be figured using this formula: coupon amount/price. So, if you buy a bond at its initial face or “par”, the yield is equal to the interest rate. But when the bond’s price changes, so does the yield.
Example: If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10%. But if the bond’s price drops to $800 in public trading, the yield jumps to 12.5%. That’s because you are guaranteed the same $100 that you were promised when the bond was priced at $1,000. Conversely, if the bond goes up in value, the yield goes down.
So, yes, generally speaking, it’s true that bond prices and yields are inversely related.
What can bonds do for my portfolio? Bonds offer several benefits as part of a well-crafted portfolio, including:
- Income – Bonds pay predictably and regularly. That interest can be re-invested while building your nest egg, or used as income in retirement.
- Security – Bonds, especially government-issued, are much less likely than stocks to lose value.
- Diversification – Bonds can add balance and range to an investment portfolio.
- Tax-savings – Some municipal bonds carry significant tax benefits as an enticement to investors.
At Wela, we believe bonds have an important role to play in every retirement investment strategy. Specifically, we think investors should “Own Their Age” in bonds. If you are 40 years old, then 40% of your portfolio should be in bonds, the rest in stocks, at 60, about 60% of your money should be in bonds, 40% in stocks. This philosophy reflects the need to pursue the growth offered by stocks in our 20s and 30’s, and the desire to protect our nest egg by playing it safer as we get close to retirement.
Here’s more on Wela’s OYA philosophy.
Disclosure: The information is provided to you as a resource for educational purposes only. Nothing herein should be considered investment, legal, or tax advice. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. It is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.