What the Online Investor Needs to Know About Bonds - dummies

What the Online Investor Needs to Know About Bonds

By Matt Krantz

If you’ve ever lent money to someone and set up a repayment program, you already know what a bond is. A bond is an IOU that entitles you to a stream of payments from the borrower. Companies, governments, cities, and government agencies often sell bonds so that they can raise money to build facilities, build bridges, or finance their operations.

The money that was borrowed (called the principal) must be repaid over time at a predetermined interest rate and returned in full by a set period of time in the future (called the maturity date). This means that when you buy most bonds, you lend your money and then sit back and collect a stream of payments until the loan comes due. Not all bonds are alike, though. There are even some bonds, called zero-coupon bonds, where you lend money now but are paid back with interest in one big chunk in the future.

Bonds by their nature offer investors several benefits:

  • Generally stable and predictable cash payments: Investors who aren’t looking for any big surprises tend to appreciate bonds’ preset rate of return. When you buy a bond and hold it until maturity, you know ahead of time what your return will be. This can be useful for reaching financial obligations.

  • Repayment of principal: When you buy a bond, you’ll receive interest payments in addition to the money you loaned back, as long as the borrower can afford the payments and doesn’t default. Investors who want to preserve their initial investment like bonds for this very reason.

  • Liquidity: You might be familiar with bank certificates of deposit (CDs), which also pay interest and return the original investments. But unlike most CDs, which you must hold for a set period of time or pay a penalty, you can sell your bonds to other investors, in most cases, at any time just like you’d sell a stock. This characteristic of bonds means you can raise cash if you need to.

    You have two ways to make money from a bond. You can hold it until it comes due, or matures. That way, you collect the interest as it’s paid. Your other option is to sell the bond to someone else before it matures. Just remember, though, when you sell a bond, you might not get back what you paid. The bond’s price might fall if the bond becomes less desirable.

  • Diversification: Bond prices tend to move up and down in a different pattern than stock prices. By owning stocks and bonds, you can smooth out the bumps in your portfolio. The table shows you how bonds might not go up as much as stocks, but they don’t usually fall as much either. It’s not just theory, as the table below shows. The worst-ever loss by long-term Treasurys was –14.9 percent in 2009, which is downright puny next to stocks’ worst year, a 43.3 percent decline in 1931.

Biggest Gains and Losses for Stocks and Bonds
Investment Biggest Gain, % Biggest Loss, %
Stocks (Standard & Poor’s 500) 54.0 (1933) –43.3 (1931)
Corporate bonds 42.6 (1982) –8.1 (1969)
Short-term Treasury bills 14.7 (1981) 0 (1938)
Intermediate-term Treasurys 29.1 (1982) –5.1 (1994)
Long-term Treasurys 40.4 (1982) –14.9 (2009)

Source: Morningstar, using data from 1926 through 2015

Typically, investors who need a more stable portfolio place most of their investments in bonds. But even if you’re terrified of the thought of losing money, it’s usually not a good idea to put your entire portfolio in bonds. Mixing some stocks in your portfolio can reduce your risk and increase your returns because bonds and stocks usually don’t rise and fall at the same time by the same degree.