Stocks and bonds. You hear people talking about these two important topics all the time. Do you understand exactly what they mean though? Sure, investments, but what type of investments. Understanding what you are (or aren’t) investing in it a key part of intelligent investing.

Treasury Bond

We already provided an easy answer to “What are stocks“, so now is the time to answer: What are bonds?

A bond is really just a loan

A bond is a loan toa company or organization froman investor.

So when you buy a bond or a fund that holds bonds, you are lending money to the issuer of the bond. Buy a bond from a company, say for $1,000, and you’re going to hand over the $1,000 loan amount. Then you’ll get fixed payments over the term of the loan equal to the interest rate offered. You’ll also get your $1,000 back at the end of the bond term.

The thousand dollars was loaned to the company, who paid back interest and the loan principal.

Bonds Provide Fixed Income

Bonds are considered “fixed income” investments because they have a set interest rate when they are originally issued.

While the bond’s interest rate never changes, sometimes the price of the bond does. That change in bond price impacts the return, or the effective rate, provided by the bond. (*Example lower in the post).

Even though the price of bonds do change, historically those fluctuations are WAY smaller than fluctuations in stock prices. This is why investors with lower risk tolerances often have a portion of their investment portfolio allocated to investment bonds.

Understanding Bonds and Risk

Bonds are generally considered lower risk than stock holdings, but this isn’t as cut-and-dry as some people believe. It largely depends on the type of risk an investor is concerned about.

Volatility Risk

Volatility means changes in value. When you make an investment you buy in at a certain price and that price will change over time. It might go up, go down, or remain steady. Chances are that it will do all three of these things at some point.

Stock prices tend to fluctuate a lot more than bond prices. If you don’t need the investment money back for a long time, these fluctuations likely shouldn’t matter to you. If prices go down one year, they’re just as likely to go back up the next. It’s just the nature of investing.

As you get closer to the point of needing the investment money back though, you might want to smooth out those fluctuations. With less time to recover from a drop, it would be reasonable to take action to minimize price swings.

That’s where bonds come in.

A portfolio that has some portion of bonds versus all stocks is going to fluctuate less in value. It won’t have dropped as large as a total stock investment. Of course, it also won’t have gained as large either (see below for more on that).

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Sequence Of Returns Risk

There is another risk that bonds help guard against that doesn’t kick in until you reach retirement. It’s called sequence of returns risk.

It’s fairly common knowledge that stocks return about 10% per year on average. If we all just saw our portfolios grow 10% every year, that would be great and planning would be easy!

That’s an average though. There have been stretches in the past where stock values have dropped almost in half for a year or two.

In retirement, you are drawing money from your investment accounts regularly to cover living expenses. When you are drawing down your retirement investments at the same time they are in a down cycle, this can cause problems. Selling investments while they are down means locking in losses. It also means a smaller portfolio balance to participate in the recovery when it happens.

Sequence of returns risk means that you don’t know what any single year will produce for your investments. If it’s a good year, everything is fine. If it’s a rough year, it creates a challenge.

Having a portion of your investments in bonds helps smooth these swings and lowers the impact of the sequence of the returns.

Default Risk

US Treasury Bonds are considered extremely low risk because they are backed up by the US Federal Government.

Risk levels for corporate bonds vary depending on the specifics of the company and its operations. The two biggest and most common rating organizations are Moodys and S&P. Both analyze many factors of the issuing organization then assign a rating that reflects their expectation of potential default or loss on the bonds.

Higher risk corporate bonds pay higher interest rates. Lower risk bonds, like US Treasuries, pay a lower interest rate. It’s a standard risk-reward situation that investors need to consider.

Purchasing Power (Inflation) Risk

Below you can see a chart of the prices from ten years leading to March 2016. This shows the Vanguard Total Bond Market ETF (blue line) compared to the SPDR S&P 500 ETF (red line). You can see that the value of the bond (specifically the price) varies very little over time compared to stocks.

10-year comparison of BND and SPY

While holding investment bonds that may have very little change in price can help address market fluctuation anxiety, there is still a big risk related to inflation. Specifically the growth of the holdings not keeping up with inflation.

This can cause your “real purchasing power” to be lower in the future when you need to access the funds. If inflation runs 2% a year, which is a historical average that many financial advisors use for estimates, that can negate quite a lot of the gains you see in your investment bond holdings.

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Lowered Growth Potential Risk

There is also a risk related to a lack of portfolio growth. Most people use investments as a way to increase their wealth over a long horizon. Then they can use those future funds to achieve a goal – like retirement.

As shown above, for the time horizon shown, the value of an S&P stock fund like SPY has grown about four times as fast as a total market bond fund like BND. Certainly, bonds pay interest, which should be considered, but many stocks also pay dividends. In fact, in early 2016 the S&P (SPY ETF) dividend rate is very close to the yield that the BND bond fund is paying.

That nice steady blue line looks appealing in a certain sense, especially around the start of 2009 when the S&P dropped so drastically. But if you were holding investments for growth over that ten year period, the four-times higher return of the S&P fund makes a huge difference in your ability to increase wealth.

So, are bonds good or bad?

Investing in bonds is both good and bad – like many things there are trade-offs.

Depending on your tolerance for risk, you might want a certain portion of your investments held in bonds.

If you have a long investment time horizon (ten years or longer) and can stand fluctuations without panic and – this is important – you won’t need any of the invested capital for that same horizon, you might want to consider minimal or no bond holdings.

Side note: If you’ve ever studied Dave Ramsey’s Financial Peace University material you likely noticed that he doesn’t recommend any bond holdings. He recommends an equal allocation of four funds – growth, growth and income, aggressive growth, and international.

A large part of his plan though is making sure you have a long investing horizon and a good-sized emergency fund so you won’t have to touch any investments during a downturn in the market.

Hopefully, this explanation of investment bonds clarifies the topic for you to be able to make an educated decision on your own investment portfolio and understand both the benefits and the risks of allocating a portion to bonds versus stocks.

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Bond Yield Change Example

*Example of bond yield fluctuation: Say a company issued a $1,000 bond paying 5% interest and an investor buys one. This means they’ll get $50 each year in interest payments.

A year later interest rates may have risen and new bonds that companies are issuing are paying a 7% interest rate. In that case, the investor would like to sell the bond and put their money in that better rate bond, right?

Well, to entice someone to buy the bond the investor will need to sell the bond at a discount. Perhaps they offer to sell it to someone for $900. The buyer of that “discount bond” (it had to be discounted to be sold) still gets the original $1,000 back when the bond term ends. Their return on the investment in the $100 above what they paid, plus the same interest rate payment ($50 per year) as was originally agreed.

This new buyer is now getting $50 per year on a $900 investment, which works out to a 5.6% rate for them. Of course, since they also get that additional $100 return on their purchase when then bond term ends, so their total return is even better than the 5.6%.

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In Closing

Was this explanation of bonds helpful? Does it help to understand how the effective rate can change over time, even though the issued rate remains the same?