By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: June 20, 2011
What is a bond?
Many consumers have a very limited knowledge of the bond market. In part, this is because the media does not cover the bond market as thoroughly as it covers the stock market. Despite this lack of coverage, bonds may represent an important part of your investment portfolio.
The fundamental difference between a stock and a bond is that owning stock in a company equates to owning a share of the company’s earnings and dividends, while owning a bond represents a loan to the company. Companies, of course, are not the only issuers of bonds, as both national and municipal governments also borrow money in the bond market. But the basic principle remains: if you own a bond, the issuer is a debtor and you are a creditor. As a creditor, you are lending money to the issuer of a bond, who is obligated to repay your loan with interest.
How do bonds differ from stocks?
If you own a bond you do not own a piece of a company’s earnings, so you will not have the same upside as if you owned the stock and the company performed well. But while the upside may be more limited, so is the downside because bonds get paid before stock dividends. Bonds are intrinsically less risky than stocks because, if a company does not perform well, bondholders will still get paid. And in the event of a bankruptcy, bondholders have a priority claim on company assets. That means if you own the bond of a company that has filed for bankruptcy, you are the first to get paid; and as a bondholder, you may get some or even all of your investment back while stockholders rarely get anything.
In general, most bonds involve less risk (as measured by volatility) than stocks because nothing is higher in the capital structure of a company than obligations to bondholders.
What kind of a return can I expect when investing in bonds?
Although a diversified portfolio of high quality bonds is generally less risky than a diversified portfolio of stocks, lower risk does equate to lower returns. Historically major stock market indexes have averaged long-term, inflation-adjusted returns of about seven percent per year. A well diversified portfolio of high quality corporate bonds will typically beat inflation by about two percent per year. Like the stock market, however, the bond market has many different segments, and some of these can be even riskier than the stock market. So while you can achieve higher returns in the bond market, higher returns are usually accompanied by more risk.
There are many types of bond issuers. Your bond portfolio may include U.S. Treasury bonds issued by the federal government, municipal bonds issued by a local city, or high quality corporate bonds issued by companies like General Electric. Your bond holdings may even incorporate some less conventional segments of the bond market such as inflation-protected bonds and bonds issued by foreign governments that are denominated in foreign currency. Typically stronger issuers pay less interest than weak issuers; and U.S. Treasury bonds, which are guaranteed by the full faith and credit of the U.S. government, pay the lowest interest of any type of bond. On the other end of the spectrum are high yield bonds, which are also known as “junk” bonds. High yield bonds pay relatively high rates of interest in order to attract lenders to companies with weaker balance sheets. As a result, these bonds pay you relatively high levels of interest to compensate you for the higher level of credit risk that you are accepting.
What kind of risks are there in the bond market?
The two main types of risk in the bond market are credit risk and interest rate risk. Credit risk is the risk that you will not be paid if the issuer defaults; this risk can be minimized through prudent diversification and by holding bonds that are issued by financially stable governments and corporations. If you are not looking to take a lot of risk in your bond portfolio, you may want to forego higher yielding bonds for some higher quality bonds that pay less interest.
Interest rate risk results from the fact that bond prices are inversely correlated with changes in general interest rates. Increases in interest rates result in lower bond prices and vice versa. Imagine that you are holding a $1,000 bond paying five percent annual interest, but suddenly interest rates go up one full percentage point to six percent. If someone can buy a newly issued six percent bond for $1,000 that pays $60 a year and your five percent bond only pays $50 per year, your “old” five percent bond will be worth less than it was before rates went up. Of course, if rates go down to four percent, your five percent bond would increase in value. The change in the value of your bond will depend on its duration, which is a measure of how sensitive a bond or bond portfolio is to changes in interest rates. Although duration has many components, longer-term bonds generally entail more duration than shorter-term bonds. Limiting the duration of your bonds can help you manage your exposure to interest rate risk.
Since you can use duration to select bonds with different levels of interest rate risk, bond investments can be appropriate for investors with relatively short time horizons. These short-term portfolios can further minimize risk by focusing on high quality issuers. So while most financial planners agree that a time horizon of at least five years is necessary for investing in stocks, investments in bonds can be appropriate for shorter time horizons because of their lower level of risk. Accordingly, short-term bond investments can be appropriate for investors with time horizons as short as one year.
How can I invest in the bond market?
There are many different ways to invest in the bond market. You can buy bonds directly from some entities, like the U.S. Treasury. Bonds can also be purchased individually in the open market through a broker, or you can acquire shares of a professionally managed portfolio of bonds by buying a mutual fund that can provide diversification with a single holding. If you are not sure how to achieve the right balance of risk and reward for your money, consider consulting with a financial planner who can construct a bond portfolio that is consistent with your risk tolerance and investment objectives.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif. He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.