Bonds – A solid move or pass?

Both stocks and bonds are essential to investment diversification and both have their pros and cons.

Essentially, the difference between stocks and bonds can be summed up in one phrase: debt versus equity. Bonds represent debt and stocks represent equity ownership. This difference brings us to the first main advantage of bonds: In general, investing in debt is relatively safer than investing in equity. That’s because debt holders have priority over shareholders—for instance, if a company goes bankrupt, debt holders (creditors) are ahead of shareholders in the line to be paid. In this worst-case scenario, the creditors might get at least some of their money back, while shareholders might lose their entire investment, depending on the value of the assets liquidated by the bankrupt company.

A bond represents a promise by a borrower to pay a lender their principal and usually interest on a loan. Governments and businesses issue bonds to raise money. By buying a bond, you give the issuer a loan, and they commit to pay you back the face value of the loan on a particular date plus periodic interest payments, generally twice a year. The interest rates on bonds are often higher than the deposit rates offered by banks on savings accounts and certificates of deposit. Therefore, if you are saving and do not need the money in the near future (within a year or less), bonds will provide you with a significantly higher rate of return without exposing you to excessive risk.

Company bonds don’t grant ownership rights, unlike stocks. You don’t necessarily gain from the company’s development, but you won’t see much harm when it’s not doing well, either, as long as it can pay its debts.

Companies, governments and municipalities issue bonds to get money for various things, which may include:

• Providing operating cash flow;

• Financing debt;

• Funding capital investments in schools, highways, hospitals, and other projects.

Bonds can provide the following benefits to your portfolio:

• Bonds can provide a means of preserving capital and earning a predictable return. Bond investments provide steady streams of income from interest payments prior to maturity.

• If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.

• Bonds can help offset exposure to more volatile stock holdings investors may own.

• While less exciting perhaps than stocks, bonds are an important piece of any diversified portfolio.

• Bonds tend to be less volatile and less risky than stocks, and when held to maturity can offer more stable and consistent returns.

• Interest rates on bonds often tend to be higher than savings rates at banks, on CDs, or in money market accounts.

• Bonds also tend to perform well when stocks are declining, as interest rates fall and bond prices rise in turn.

Bonds can contribute an element of stability to almost any diversified portfolio – they are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are a great savings vehicle for when you don’t want to put your money at risk. Investors buy bonds because:

• They provide a predictable income stream. Typically, bonds pay interest twice a year.

• If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.

• Bonds can help offset exposure to more volatile stockholdings.

As with any investment, bonds have risks. These risks include:

Credit risk: The issuer may fail to make interest or principal payments in time and thus default on its bonds.

Interest rate risk: Interest rate changes can affect a bond’s value. Rising interest rates will make newly issued bonds more appealing to investors, because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount. If bonds are held to maturity, the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value.

Inflation risk: Inflation raises prices generally. Inflation diminishes purchasing power, putting fixed-rate instruments at risk for investors.

Liquidity risk: This refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want.

Call risk: The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.

WHAT TYPES OF BONDS ARE THERE?

There are a few main types of bonds:

• Corporate bonds are debt securities issued by private and public corporations.

• Investment-grade: These bonds have a higher credit rating, implying less credit risk, than high-yield corporate bonds.

• High-yield: These bonds have a lower credit rating, implying higher credit risk, than investment-grade bonds and, therefore, offer higher interest rates in return for the increased risk.

• Municipal bonds: Also called ‘munis’, are debt securities issued by states, cities, counties and other government entities.

BONDS, YES OR NO?

If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle. It’s not unusual for stocks to lose 10% or more in a year, so when bonds make up a portion of your portfolio, they can help smooth out the bumps when a recession comes along.

Also, in certain life situations, people may need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market. By owning bonds, retirees can predict with a greater degree of certainty how much income they’ll have in their later years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities.

The interest rates on bonds are typically greater than the deposit rates paid by banks. As a result, if you are saving and you don’t need the money in the short term (in a year or less), bonds will give you a relatively better return without posing too much risk.

College savings are a good example of funds you may want to increase through investment, while also protecting them from risk. Parking your money in the bank is a start, but it’s not going to give you any return. With bonds, aspiring college students (or their parents) can predict their investment earnings and determine the amount they’ll have to contribute to accumulating their tuition nest egg by the time college starts.

There is no easy answer to how much of your portfolio should be invested in bonds. Quite often, you’ll hear an old rule that says investors should formulate their allocation among stocks, bonds, and cash by subtracting their age from 100. The resulting figure indicates the percentage of a person’s assets that should be invested in stocks, with the rest spread between bonds and cash. According to this rule, a 20-year-old should have 80% in stocks and 20% in cash and bonds, while someone who is 65 should have 35% of his or her assets in stocks and 65% in bonds and cash.

That being said, Bonds are a resounding yes! Diversifying is key in all investment, so mix it up!