Investing 101: Bonds

(This is the second in a regular series where I attempt to explain some common investments and other financial terms. Enjoy the knowledge and sharing.)

Q: So, what exactly are bonds?

A: Simply put, bonds are IOUs. When companies, governments, or even individuals (remember Bowie bonds?) need money, they can sell bonds, allowing them to raise capital and pay it back later.

Q: Why would I want to lend money to people I don’t even know?

A: Well, unlike loans you make to family members or friends, when you purchase a bond, you’ll gain additional money. If you hold onto your bond, you’ll receive regular payments (called dividends), usually twice each year. When the bond matures (that is, when the duration of the loan is over), you’ll receive your money back.

Q: Sounds pretty good to me! How can I lose?

A: There are a few drawbacks to bond investing, unfortunately. They tend to yield less than investments in stocks; if we look at the returns between 1926 and 2007, we see an average return on bond investments of 5.5% compared to 10.4% for stock investments. And unlike certain qualified stock dividends, bond dividends are taxed at your normal income rate.

Plus, there is always the risk that the company or other bond issuing agency could default.

Q: Wait, what? What’s this about default?

A: Well, yeah. If your bond issuers go bankrupt, they may not be able to repay their creditors (which, if you own bonds, will include you). You will be somewhat better off than stock holders (as they are considered part owners, when the company goes under, they lose all their investment), but you might only get a small portion of your investment back, if any. You can avoid this situation, or at least minimize the possibility, if you stick to highly rated, ‘investment grade’ bonds.

Q: Bond ratings, you say?

A: Yes, there are agencies that review the companies, governments, and agencies that issue bonds, including Moody’s, Standard & Poor’s, and Fitch. They classify bonds according to the risk of default, from AAA (or Aaa), the rock-solid, safe as can be issuers, all the way down to D, already in default. Sticking with the bonds rated at least BBB (the fourth highest rank, the lowest investment grade ranking) will all but eliminate the chance of default.

(A caveat, though: many of the mortgage backed securities and their derivatives were ranked AAA by the rating agencies. A high ranking shouldn’t be the end of your research into the bond issuers in which you intend to invest.)

Q: So, if I stick with high rated bonds, there’s no worries?

A: No, sorry, you’re not out of the woods yet. Bond yields are determined by the prevailing interest rates. When rates are high, bond issuers have to pay more to get investors (since the investors have many other options that will give them good return on their money). When rates are low (as they are now), you won’t get a high return from bonds. If you buy bonds when interest rates are low and then the rates rise, the amount the bonds can be sold for will decrease.

Even if you manage to buy the bonds when they’re yielding a high return, there’s the possibility that the bond will be called. In these cases, the bond issuer will pay back your principal early, essentially ending your dividend payments and forcing you to find somewhere else to invest.

Q: Arrgh, with all these drawbacks, why would anyone invest in bonds?

A: There are several reasons to invest in bonds. First, bonds are still very safe investments. The risk of default on investment grade bonds is under 2% (and AAA ranked bonds default about 0.1%), meaning that over 98% of investment grade bonds make it to maturity (or are called ahead of time) without incident.

Bonds also tend to be much more stable investments than stocks. Look back at the comparison of stock and bond portfolios; the worst loss an all-bond portfolio suffered was a loss of 8% in one year, compared to a worst-case result of losing 43% in all stocks. Adding bonds to your portfolio will diversify your holdings, help to smooth out your investment returns and make your portfolio more stable.

If you’re looking for current income, bonds are one of the best sources. The dividend rate you get from bonds usually exceeds what you can get from stocks. In addition, it’s difficult for companies to cut bond dividends without recalling the bonds, so your income stream is safer when investing in bonds than when investing in stocks.

Q: Alright, I’m sold. How do I buy bonds?

A: Well, you can buy bonds directly, from a site like PIMCO or FINRA. (Or US Government Treasuries at the Treasury website) Bonds do tend to be rather pricey, however, frequently selling for $1,000 (or more) each. This makes it tough to build a diverse portfolio as a relatively small investor; most investment advisors recommend between $25,000 and $50,000 to get started in bond investing.

For most investors, getting a diverse portfolio of bonds, enough to ensure that a possible default or two won’t upset your investment plans, the best bet is a bond mutual fund. There are a variety of bond mutual funds available, from companies like Vanguard, Fidelity, and T. Rowe Price. These fund give you exposure to bonds, but are much more diverse.

For a more complete comparison of bonds and bond funds, you’ll just have to wait until tomorrow…

Q: Awww, do I have to?

Yes, yes you do. But have a good time until then!

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