So far, I have only written about stocks and groups of stocks. The other side of the coin is the bond market, which is almost twice the size of the stock market. Almost everyone has some allocation to bonds, whether through individual bonds, a bond mutual fund or ETF, or even indirectly through a life insurance policy, since the insurer has a heavy bond allocation.
A bond is simply an IOU–you, as the bondholder, loan money to a company, and it agrees to pay you that money back with interest. The most important thing to understand about bonds is that the price of a bond moves in the opposite direction of its yield, i.e., the interest paid divided by the price. If interest rates go up, then the price of bonds go down, because new debt will have a higher interest rate, making the current bonds at lower interest rates less valuable. The price of a bond can also fluctuate based on the likelihood of the bond being repaid. For example, when Puerto Rico announced that it was likely to default on its bonds, the price of those bonds went down considerably. When the price of a bond goes down or up, whether due to interest rate changes or the odds of repayment changing, that price only applies if you buy or sell the bond. If you buy a bond of Apple, and hold it to maturity, then you will still get your $1,000 per bond back from Apple, even if in the meantime you could have sold it for some other price.
Here are some other basics about bonds:
- Bonds are usually purchased in $1,000 increments with an agreed upon interest rate paid monthly, quarterly, semi-annually or annually.
- Most bonds have a fixed maturity date, at which point you get your $1,000 back. Some bonds do not pay interest at all (zero-coupon bonds) but rather pay you more money back at maturity.
- Bonds are issued by federal, state and local government agencies, as well as companies of all sizes.
- There is a rating scale for bonds, with three major agencies providing the ratings. AAA is better than AA, “A”s are better than “B”s, etc. BB and worse rated bonds are considered junk bonds.
- Although we don’t hear about it nearly as much as stocks, there are thousands of people whose sole job it is to evaluate bonds, the likelihood of repayment, whether the bond is undervalued or overvalued, etc., much like the stock market.
- Bonds are considered to be safer than stocks because they have priority over the stockholders of a company in the event of bankruptcy, meaning that bondholders are likely to get some portion of their loan paid back, whereas stockholders are more likely to get nothing for their stock.
The expected return of a bond is its starting yield. If you purchase the bond at “par value”, which means the original issue price (usually $1,000), then your expected return is simply the interest rate. If you purchase the bond from someone else, like through the publicly traded bond market, then you adjust the interest rate for the price you paid for the bond to figure out your effective interest rate, which is your expected return. For example, Intel has a bond maturing in 2045 that pays interest at 4.9%. With interest rates being so low, and with Intel being extremely likely to repay this debt, the bond is selling for a premium, meaning that you have to pay more than $1,000 to get one of its bonds. Because you have to pay approximately $1,100 per bond, even though you will only get $1,000 per bond back at maturity, then the interest payments of $49 per year does not equal a 4.9% interest rate, but rather 4.45% (49/1100). As a result, your expected return is 4.45%.
Finally, bonds are important because they provide diversification. Over the past ten years, bonds have close to no correlation to stocks, meaning that they do not tend to move in the same direction. If anything, U.S. government bonds often move in the opposite direction of stocks. This is crucial because if an investor’s stock allocation is stuck in a bear market during retirement, then hopefully her bond allocation will hold steady or increase in value, thereby smoothing out the portfolio’s risk and return.