Personally, I think bonds are boring. I’m also young and not afraid to take on risk, so I might be a little bit biased.
Bonds, while not as glamorous as stocks, are a major portion of the world’s investments. According to this article from the Motley Fool, the worldwide bond market is valued at $100 trillion, while the worldwide stock market comes in at $64 trillion. In the U.S. alone, $40 trillion is in bonds while $20 trillion is in stocks. Pretty freakin’ huge.
But if the bond market is so much bigger, why is so much pressure put on us to get into the stock market early in our careers?
Bonds are usually lower risk, and therefore yield lower returns. NYU has compiled a pretty cool chart that compares the returns of the stock market, treasury bills (short-term government debt), and treasury bonds (longer-term government debt). It shows that the worst year for bonds ended up with a loss of 11%, while the worst year for stocks ended up losing 43%. I think it’s fair to say we’d all prefer the former.
However, the best year for bonds had a return of 33%, whereas the best stock market return yielded 53%. The greater the risk, the greater the potential return. NYU’s chart also shows what would have happened if you had invest $100 in the stock market and in government bonds in 1928. Treasury bonds would have turned that $100 into an impressive $7,000, but the stock market would’ve turned that $100 into a whopping $294,000.
I know what you’re thinking. Why the heck would anyone invest in bonds instead of stocks? Trust me, there are a few pretty good reasons.
But first, we should understand what bonds actually are.
What is a Bond?
A bond is basically a loan. When a government (local, state, federal), business, or other entity need/want to raise money, they may decide to issue bonds. People/businesses/whoever can then purchase these bonds in exchange for interest payments and a loan repayment.
These investments can vary dramatically in duration, interest rates, and types of repayment, depending on the issuer’s stated terms. Some bonds mature (are repaid) after one day, while others have 100 years to maturity. Interest rates also are somewhat dependent on how long a bond takes to mature, as a longer duration means a greater risk. Your odds of being repaid tomorrow are a lot higher than your odds of being repaid in 100 years!
Along with the risk element, interest rates also increase if the bond issuer is determined to be a more risky investment. Three major agencies (Moody’s, S&P, and Fitch) decide how risky a company or government is, and the ratings assigned to the bond issuer essentially dictate the interest rate investors would require.
The scales are a little bit different between the companies, but the best rating a company can get will be three A’s (Aaa or AAA). Basically, a triple A rating means that the issuer is very strong financially, and is thus a low risk. Since there is low risk, there is also low reward. On the other hand, an issuer on the brink of failure might receive a C or D rating. Because of the high risk of the entity going under, investors will need to earn more money to compensate for the chance that they will not be repaid, thereby forcing the issuer to pay a higher interest rate.
It’s a little tricky to be more specific in describing bonds because they can vary so much. As much as the terms of the issued bonds can change, the underlying principle is the same. Investors “lend” money to governments, companies, etc. in order to get a “guaranteed” return on their money.
How to Make Money from Bonds
There are several types of bonds that pay in different ways, but the two major types are coupon and zero-coupon bonds.
The latter is the simpler of the two. A zero-coupon bond basically states that you pay X dollars (face value) for the bond, and when it matures, the issuer pays you back X dollars with a stated interest rate. So, for example, let’s say Coca-Cola is issuing one year, zero-coupon bonds with a 2% yield. If you bought a $1,000 bond, after one year, Coca-Cola will have to repay you $1,000 plus $20 (the 2%) in interest.
Coupon bonds are a little bit more complex. Back in the good ol’ days, bonds had little slips (coupons) that you would tear off and redeem for money. So, a 10 year bond with annual coupons would have 10 slips attached to it.
These physical coupons aren’t as common anymore, but the idea is the same. Every year (or whatever the bond terms are – semi-annual, etc.), the owner of the bond will be able to collect a payment. Then, at maturity, the face value of the bond is repaid. We could say that Ford is issuing 5 year coupon bonds with 5% annual payments. So, you, being the savvy, risk-avoiding investor, decide to purchase $1,000 worth. Every year for 5 years, you will receive a $50 payment (5%), and then at the end of the bond’s life, you’ll also be repaid the $1,000 face value. Total repayment, ( 5 x $50 ) + $1,000 = $1,250.
While guaranteed payments are definitely nice, there’s another way to make money with bonds. Bond prices fluctuate with supply and demand, so if the demand for your bond rises, the price will also rise. At this point, you might decide to sell early and take the quick win. Demand for your bond is based on the rates of return in the bond market. If interest rates on bonds in the market are higher than the rate on your bond, the value of your bond will decrease.
This is confusing stuff. I still struggle with it.
Rather than having me butcher an explanation, I’d suggest reading this example from Investopedia. I think they do a pretty solid job in explaining the idea, but it’s still a pretty confusing topic anyway. Luckily, you don’t ever have to use this strategy if you don’t want to!
Bonds can be less sexy and more confusing than stocks. However, if you want to retire, chances are that you’ll plow a pretty significant chunk of your savings into the bond market.
Yes, the returns in the bond market aren’t nearly as strong as in the stock market. Your risk is significantly lower, though. Can you think of a point in your life that you REALLY don’t want to risk losing your life’s savings?
Right before, and during, retirement, perhaps?
I’ve been thinking about being a freelance graphic designer – thoughts?
The beautiful graphic above represents the stock market, and by extension, your retirement portfolio. If the stock market plummets 50% right before you retire, that would suck. You’d have half as much to live off of, and you’re going to be praying for it to rebound.
Had you gone more heavily into bonds in the years leading up to retirement, your savings would probably still be intact. Slower growing, yes, but at least it’s not gone.
Most advisors and experts will tell younger people to put more of their savings into the stock market, and will tell older people to lean more heavily into bonds. I don’t disagree. Figure out wherever you’re at in life, decide how much risk you’re willing to take, and start investing.
Even if you don’t care about bonds now, you eventually will. So pay attention!
How much of your portfolio is in bonds? Do you have too much or too little risk? Leave comments below and share!