| What They Are |
Bonds do not give investors an ownership stake in a company, like stocks do. A bond is a loan from an investor to a corporation or a government. The investor loans the corporation or government cash and in exchange receives interest payments and a return of the initial loan (principal) at the end of the life of the bond (maturity date). Every bond issued has a fixed maturity date, which can vary from a few months to a few decades. When a bond matures the borrower must pay the lender back the full value of the bond (the par value). The amount of interest that different bonds pay (expressed as a percentage -- bond yield) varies depending on a variety of factors. These include other interest rates, inflation, the risk that the borrower will default on the loan, and attributes of the bond such as whether or not the bond can be called or converted. Paying a set amount of interest is one of the major advantages of bonds. Many investors need a steady stream of income from their investments, and bonds can be a great income-generating vehicle. Bonds also tend to be less volatile than stocks, offering greater protection from stock market downturns.
While bonds do offer some protection from stock volatility, they do not offer protection from inflation. Inflation risk is the single most important risk factor to take into consideration when buying bonds. The prices of all bonds fluctuate with inflation, and newly issued bonds pay rates that vary with inflation. For example, if an investor purchases a 30 year treasury bond at an interest rate of 6%, when inflation is 2%, he earns an after tax rate of return of 4%. This means that while his wealth increases by 6% per year, the purchasing power of his wealth only increases by 4% per year. This may seem fine at the time that he purchases the bond, but if inflation rises, the situation changes drastically. If inflation rises to 8% the investor is still earning a 6% return on his investment, but inflation is decreasing the purchasing power of his money by 8%. So his after tax rate of return is actually negative. If he decides to sell his bond and buy a newly issued bond, he will find that the rate of return on new bonds is much higher (it may be 12%). However, he will also find that the value of his bond has fallen considerably. He could sell it at a loss (less than par value), or he could simply hold on to it and receive the par value when it matures. Either way, his returns have been hurt considerably by inflation.
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| What They Can Do For Your Portfolio |
So how do you take advantage of the protection and income bonds offer, without risking losing too much money to inflation?
Answer: Combine the power of stocks and bonds.
Combining the power of stocks and bonds allows investors to take advantage of the attributes of both, without suffering too much from their drawbacks. The table below summarizes the advantages and disadvantages of stocks and bonds.
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Stocks
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- High long term returns
- Low inflation risk
- Ownership in a company
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- Higher volatility
- Income is not guaranteed (dividends may be cut)
- Greater chance of losing all of your investment in a single security Bonds
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Bonds
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- Steady stream of income
- Lower volatility
- Investment is relatively secure
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- Lower returns
- High inflation risk
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So the big question is how much money do you put in stocks and how much in bonds? There is no magic answer to this question. It depends on your age, financial goals, risk tolerance, and other factors.
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| Price-Yield Relationship |
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Investors getting into bonds need to have a fundamental understanding of how the yield relates to the price. When you hear prices quoted in the market, the prices referred to are the current market prices and the current yields of bonds. Since the current yield is tied directly to the current price with an inverse relationship (current yield = coupon / current price), a bond's yield moves in the opposite direction of its market price. If bond's price rises, it's yield will fall, and vice-versa.
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