What is a bond? What you need to know about managing risk

Happy retirement-aged woman

Bonds can be great low-risk investments but chances are you have never purchased a bond … and probably never will.

Same with me.

I simply don’t have the capital to commit over $100,000 to purchase the typical bond. But I do believe there are reasons to learn about bonds nonetheless, even if it’s an investment you don’t think you’ll ever make. Never say “never,” right? Well, the fact is…

You may already be invested in bonds

Whether directly or indirectly, you may already be invested in bonds through your retirement plan, mutual fund or even an annuity. In that case, knowing how the bond market works can help you make better, more informed decisions about your financial future instead of blindly trusting that someone else will put your interests ahead of their own.

Here are a few cases that may suggest a second look at bonds followed by 11 things you should know about bonds. As always, get specific investment advice from a certified professional.

You need to diversify

The need to diversify is a basic concept that virtually everyone learns as they start investing. Certainly, any experienced investor will confirm that diversification is one of the main considerations for long-term investing success. But if you’re already invested in stocks or stock index funds and want to diversify, what do you diversify into? Generally speaking, the number one investment alternative is bonds.

You need to manage risk and preserve your capital

Everyone knows the stock market can be risky. If you understand the bond market, it can give you close to a risk-free investment. Of course, the return from low-risk investments is lower; but if low risk is what you are looking for, the bond market is pretty close to the only place you can get it.

You think stocks are the only way to invest

If you watch the evening news, it’s easy to conclude that the stock market is the most important investment market out there. Wrong. Globally, the bond market is more than twice the size of the stock market. Moreover, most paid investment professionals regard the bond market as the foundation of all securities investments, not the stock market. When the bond market sneezes, the world’s economy catches a cold. From my perspective, not understanding the most significant investment market is tantamount to flying blind.

Related >> Investing 101: How Bonds Work

11 things to know about bonds

Bonds have a few attributes which, on their own, may seem obvious and even irrelevant. However, when you put them together, you begin to understand why the wealthiest individuals and financial powerhouses prefer bonds over equities (stocks).

  1. A bond is a debt instrument

    Cities, counties, school boards, corporations and governments use bonds to borrow money. Issuing bonds allows them to borrow from thousands of investors instead of a single bank.

  2. A bond is repaid

    Whereas stocks last forever (or at least until the company is taken over or goes under), bonds have a finite life. As with all loans, bonds get repaid. Some bonds get repaid five years from their date of issue, some within 20 years, and some after 50 or even a hundred years. Investing $100,000 and getting all $100,000 back is a major attraction to any investor — and it also helps explain why large investors love bonds.

  3. A bond is repaid on its maturity date

    The date a bond gets repaid is known as its maturity date. For example, Apple issued bonds in 2015 as a way to take on debt so they didn’t have to repatriate the billions of dollars in cash they keep overseas. They issued $2 billion worth of bonds with a term of 30 years, which means they will repay the $2 billion in February of 2035. They also issued some 5-year bonds which will be repaid in February of 2020. The amount that is repaid to the bond holder at maturity is known as the “face value.”

  4. A bond does not grow

    With so much attention focused on growth in the stock market, many individuals do a double take when they hear the largest investment category in the world is guaranteed not to have any growth. But it’s true: In 2035, Apple will repay all the holders of those $2 billion in bonds exactly $2 billion.

Why in the world, then, do investors flock to bonds? The first reason is the low risk mentioned above. The second reason is…

  1. A bond pays cash interest

    Many stocks never pay a dividend. Warren Buffett’s company, Berkshire Hathaway, is famous for never having paid a cent in dividends. It may come as a bit of a surprise to those just starting to invest, but most of the world’s seasoned investors will only invest in something that gives them a cash income on a regular basis. (Mr. Buffett, for example, will only invest in businesses which provide a generous quarterly cash flow.)

    The investment yielding regular cash flow more than almost any other is bonds. Bonds usually yield a check in the mail for interest every quarter. The rate of interest (commonly called “the coupon rate”) is fixed at the time the bond is issued.

  2. A bond can be liquidated before it matures

    If you own a group of those Apple bonds which mature in 2035 and you need to raise some cash due to unforeseen circumstances, you have an out. There is a bond market, as active as the stock market, where bonds change hands every day. If you still get and read a newspaper, you will see bond listings right alongside the various stock market listings.

  3. The market price of a bond can fluctuate

    One of the attributes that sets the bond market apart from the stock market is how the pricing works. Corporations grow and their profits grow; and over the long term, that is what causes individual stock prices to grow and make the stock market as a whole grow too.

    But as I mentioned above, bonds don’t grow. However, the market values of bonds do go up and down. The primary cause of those bond-price movements is interest rates. The explanation is too long to include here, but there is an inverse relationship of interest rates to bond values.

Good to know — the inverse relationship of interest rates to bond values:

  • When interest rates go up, bond values go down.
  • When interest rates go down, bond values go up.
  1. A bond has a dual liquidation value

    This is one of the most unique features of a bond as an investment: It has two possible liquidation values. If you hold the bond until it matures, you will get back the full face value of the bond. However, if you sell it on the open market, you may get either more or less than the maturity value.

    In times of dropping interest rates, you generally make a profit on the sale of a bond prior to its maturity. However, when interest rates rise, you are likely to lose money when you sell a bond. (This is why the big-money investors watch the Federal Reserve Board’s interest rate moves like a hawk.)

  2. A bond is rated for risk

    One of the main reason investors love bonds is the exposure to risk is generally low. But as also noted above, bonds often have long lives and, as we all know, things change as time passes. Sometimes risk shifts as a result of those changes.

    For example, the clothing manufacturer Liz Claiborne was a hot brand a decade or two ago. The company was quite sound and profitable. They issued bonds back then; but fashions changed, causing the company to fall on hard times. Enter the risk watchdogs: the ratings agencies.

    Risk is such an issue in the minds of bond investors that an entire industry (started by the now-well-known pair, Mr. Standard and Mr. Poor) sprung up to calculate and publish the risk for pretty much every bond that is traded on the open market. With such complete information available to investors, if a company wants to raise money by issuing bonds, they would be dead in the water without a rating.

    Usually, investors will not touch unrated bonds. And so, as Liz Claiborne’s financial condition began to deteriorate, the ratings agencies began to question the company’s ability to repay those bonds and began to downgrade their bonds. When that happens, investors want a higher return to compensate for the higher risk.

  3. A bond issuer can default on a bond

    The greatest risk on a bond is a default. Even though the percentage of all issues outstanding which default is minuscule, defaults do happen. However, because the ratings agencies monitor issuers’ ability to repay, investors have plenty of time to sell those bonds with minor losses. By the time a default actually occurs, the only investors left are those who relish the high risk.

  4. There is a fail-safe in the event of default

    Does the word “default” conjure up images of losing all your money? Think again. When the City of Detroit famously defaulted on its bonds in 2013, bond holders did not lose everything. In fact, most didn’t lose a penny because the bonds were insured. (That’s right. You can insure bonds, but not stocks.) Others got wind of Detroit’s deterioration a long time ago and sold their bonds when the losses were still minor. In practice, therefore, defaults are not nearly the catastrophe the popular press likes to paint.

The big picture on low-risk investments

Even though nothing is totally risk-free, bonds usually offer the lowest level of investment risk. Of all the bonds you can buy in the world, United States government bonds are generally considered the safest. The U.S. has never defaulted on any of its bonds before. Granted, the future is not always the same as the past, but upon what else can you make a determination?

Therefore, the rate the U.S. pays on its bonds is generally considered the risk-free rate of return. Any other investment you make, because it carries a higher risk, has to offer investors a higher rate of return. In other words, the U.S. bond interest rate is the floor in terms of the overall investment market. Which is just one more reason you, like all other investors, need to have a basic understanding of the bond market, the cornerstone of the overall investment market.

If you’ve never invested in a bond, would you consider diversifying with them? If you have invested in bonds, did it present any issues? What are the benefits/downsides as you see it?

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