We often hear of “stocks and bonds.” Stocks represent ownership of companies; bonds represent debt, money you have loaned to a company or a government. Bonds have face value (principal), interest, and a maturity date. A single bond generally stands for $1000 of borrowed money. The bondholder receives interest twice each year and gets his $1000 back at the end of the loan period, be it one, three, five, 10 years, or longer.
The bondholder will receive the face amount of the bond back when it matures. If he decides to sell the bond before its term, he will get back more or less than the face amount depending on how the interest rate at the time of sale compares to the interest rate of the bond itself. If the bond interest rate is 3% and the prevailing interest rate is 6%, nobody would want to buy a 3% bond when they could buy a new one at 6%. So the bond, if sold before maturity, is worth less than $1000. Likewise if the current interest rate is only 1%, the 3% bond will fetch more than $1000. When interest rates go up, the present value of the bond goes down. And when interest rates go down, the value of the bond goes up. At maturity the bond can be redeemed at its full face value. The current yield is the annual interest payment divided by the current price. The coupon rate is fixed for the life of the bond. The market rate changes daily as interest rates change.
Bonds, like stocks, carry many kinds of risk. Default is the risk the company or government which borrows the money will not be able to pay the money back. If a company, recent example GM, goes into bankruptcy, the bondholder does not receive all his money back. Estimates are that GM bondholders will get just 10 cents on the dollar while stockholders will get zero. The higher the risk of failure, the higher the interest rate the company must pay in order to borrow money. As we have seen from the previous paragraph, there is interest rate risk. Foreign exchange risk is present if the debt is not in U.S. dollars. Reinvestment risk comes from investing interest and principal at a lower interest rate. Possible loss of purchasing power comes if the rate of inflation exceeds the interest rate. Also, the longer time to maturity the greater the risk, and therefore, the higher the rate of interest. The longer the term of the bond, the greater will be the price volatility resulting from changes in market yields.
There are many different kinds of bonds: foreign and domestic corporate bonds; bonds issued by strong, reliable companies and bonds from companies likely to fail. There are government bonds at the municipal, state, and federal level, as well as U.S. Government Savings Bonds and I-Bonds (inflation protected). U.S. Government Bonds are the safest bonds because there is very little chance the United States will fail to repay its debt. As a result government bonds will have a lower interest rate.
An investor purchases bonds in much the same way as stocks are purchased, through a brokerage firm or commercial bank or directly from the federal government (TreasuryDirect.gov). Individual bonds generally have a commission ranging from 0.5% to 2%; there is no commission on bonds purchased directly from the U.S. government. Individual bonds are more risky than bond mutual funds or Exchange Traded Funds ETFs, which consist of a collection of bonds sold as a single package. Mutual funds have an annual management fee and ETFs have a transaction fee and an annual management fee. ETFs have perhaps the lowest total fee, followed closely by mutual funds. I recommend an ETF which contains a wide selection of different kinds of bonds. BND is the symbol for a Vanguard ETF which seeks to track the performance of a broad bond index; it invests by sampling the index.
At the present time (June 2009) interest rates are very low; the only way they can go is up. When interest rates do go up, the price of individual bonds as well as bond mutual funds and ETFs will go down. However, interest rates are expected to remain relatively low for 12-18 months and rise only when the economy picks up. Broad bond indexes currently yield between 4% and 5%, and are a better place for your money right now than are CDs and savings accounts.
Should you have bonds in your investment portfolio? The answer is yes, you should have bonds in your portfolio. As a Money Coach I generally recommend that an individual portfolio contain no more than 50% equities (stocks). The remaining part of your portfolio should contain investments not tied to the stock market such as cash and several varieties of bonds. The portfolio may contain other, non-equity investments like real estate, collectibles, and business interests. The percentage in bonds depends on your age, your goals, and your overall financial situation. Ask your financial advisor.
