What Exactly is a Bond?
A typical “balanced” investment portfolio will hold both stocks and bonds as its core holdings. Most investors understand the stock portion, at least to a very basic level. They understand that buying a stock is buying a share or a small piece of a company. The price of that stock will go up or down and it may entitle the owner to a dividend payment periodically.
What the heck is a bond though and why do they seem to be so much more confusing to most investors? To help demystify bonds, I will do my best to break it down for you here:
First, a bond is really just a loan. Like a mortgage, a bond involves a lender and a borrower. And just like you or I applying for a loan, we have credit scores that affect the interest rate that we must pay on that loan.
Bonds are typically sold in $1,000 increments and they have a face or par value in the same amount. For a typical bond, the borrower (or issuer) agrees to make semi-annual payments to its creditors (the investors) until it reaches its maturity date. The amount of interest the borrower pays is based largely on their credit rating and in most cases, is fixed for the life on the bond. This is why bond investments are often referred to as “fixed income”. Upon maturing, you get your original investment back in one lump sum.
In simple terms, you would assume you would put $100,000 into a bond portfolio (purchasing 100 of the $1,000 bonds at face value) and hold it to maturity. It might pay you 3% interest per year during this time and then you get the full $100,000 back on top of the interest payments.
But, this is where it starts to get confusing. Bonds are bought and sold daily in the markets just like stocks and their values can fluctuate daily as well. In reality, you often can’t buy the bond at issue but instead need to make the purchase in the secondary market. You may pay $1,040 for each of the bonds and also incur trading or brokerage costs of another $50 per bond. The extra $90 per bond can eat up a lot of the expected interest yield.
Most bonds are not held to maturity by a single investor and when you need to sell these bonds to access your money, you again will be selling at the current market price. Interest rates will affect the current value or price of your bonds. If rates go up, the value of your bonds will go down since new bond issues will likely be paying a higher coupon rate than ones already issues. Likewise, if rates go down, the value of your bonds should increase.
This inverse relationship tends to be the most confusing part of fixed income investing for many people. The 10 year US treasury bonds are paying 2.4% right now. If rates in the US go up and 10 year treasuries start paying 2.75%, the ones you bought at 2.4% are less valuable since that lower rate is locked in for 10 more years.
With that in mind, the biggest risk to bond markets are rising interest rates and the best situation for increasing your fixed income holding’s value is a decrease in interest rates. You need to ask yourself which way you expect rates to go in the next couple of years….
While probably not sounding too attractive, bonds do have their places in most portfolios since an all stock account will be too risky for most people. Like other areas of investing, there are still some good options out there in this rising rate environment – in particular, short duration bonds (those that mature in under 2 years) and bonds that have a “floating” interest rate that will keep pace with rate increases.