Investing Advice: The Basics of Bonds
By: Steve Smith
Historically low interests rates, or the yield you can receive on bond, have been a major underpinning to the increase in stock prices. Conversely, a raise in rates could be what ultimately brings the bull market to an end. Because of the Fed’s moves in the direction of increased interest rates, however hesitant, today’s investing advice will concern the bond market.
Given the $50 trillion global bond market, which happens to nearly twice the size of global stock market, is crucial to how investment decisions get made it’s important to make sure one understands exactly what a bond is.
Below is part 1 of Bennet Sedacca’s 4 part series Bond Basics. http://www.minyanville.com/businessmarkets/articles/3/21/2006/id/9819
What Are Bonds?
- An interest-bearing instrument which promises to pay a stated amount of money at some future date.
- Bonds are redeemed at the end of a term, called a maturity date. Some bonds have “call dates.” Issuers may call bonds earlier than its maturity date if it suits them at that time. Other bonds have “put features.” This is the opposite of a call date. “Put” allows the holder to sell the bond back to the issuer at a predetermined price before the stated maturity date.
- When you buy a bond, you are in effect “lending money” to the issuer, much like an “I.O.U.”
Who Issues Bonds and Why are They Issued?
- Bonds are issued by many types of entities, including: Governments, Corporations, Municipalities and Federal Agencies.
- Bond issuers issue bonds generally to fund their operation. They pay the owner interest so long as the bond is outstanding.
- When a bond is issued, the issuer assumes that they can earn more in their business than they are paying out on the interest payments. For a corporation, by example, this means they feel their “return on equity” will exceed their interest payment rate.
- Bonds can be issued to fund an acquisition, for general corporate purposes or to pay off a maturing bond issued previously.
Why Invest in Bonds?
- Most financial advisers, investment advisers or stockbrokers recommend that portfolios are properly “balanced,” otherwise known as asset allocation.
- Bonds are generally more stable than equities and have a predictable stream of income, acting as a “shock absorber” in the overall scope of a portfolio. See the chart below, which proves that over time, using bonds to diversify lowers the risk of a portfolio, without sacrificing returns.
Risk in this case is measured as ‘standard deviation of return.’ (Data courtesy of Ibbotson)
For more investing advice, click here for the next part, Types of Bonds: