The word bond basically means an IOU. You lend your money to Uncle Sam, to General Electric, to Procter & Gamble, to the city in which you live — to whatever entity issues the bonds — and that entity promises to pay you a certain rate of interest in exchange for borrowing your money. This is very different from stock investing, where you purchase shares in a company, become an alleged partial owner of that company, and then start to pray that the company churns a profit and the CEO doesn’t pocket it all.
Stocks and bonds complement each other like peanut butter and jelly. Bonds are the peanut butter that can keep your jelly from dripping to the floor. They are the life rafts that can keep your portfolio afloat when the investment seas get choppy. Yes, bonds are also very handy as a source of steady income, but, contrary to popular myth, that should not be their major role in most portfolios.
Bonds are the sweethearts that may have saved your grandparents from selling apples on the street during the hungry 1930s. They are the babies that may have saved your 401(k) from devastation during the three growly bear-market years on Wall Street that started this century. Bonds belong in nearly every portfolio.
Almost all bonds these days are issued with life spans (maturities) of up to 30 years. Few people are interested in loaning their money for longer than that, and people young enough to think more than 30 years ahead rarely have enough money to lend. In the parlance of bond people, any bond with a maturity of less than five years is called a short bond. Bonds with maturities of 5 to 12 years are called intermediate bonds. Bonds with maturities of 12 years or more are called long bonds.
In general, the longer the maturity, the greater the interest rate paid. That’s because bond buyers generally demand more compensation the longer they agree to tie up their money. At the same time, bond issuers are willing to fork over more interest in return for the privilege of holding onto your money longer. It’s exactly the same theory and practice with bank CDs: Typically the two year CD pays more than the one-year CD, which pays more than the six month CD. The difference between the rates you can get on short bonds versus intermediate bonds versus long bonds is known as the yield curve. Yield simply refers to the annual interest rate.
Individual bonds offer investors the opportunity to really fine-tune a fixed income portfolio. With individual bonds, you can choose exactly what you want in terms of bond quality, maturity, and taxability. For larger investors investing in individual bonds may also be more economical than investing in a bond fund. That’s especially true for those investors up on the latest advances in bond buying and selling.
On the other hand, I’m a big advocate of bond funds — both bond mutual funds and exchange traded funds. Mutual funds and exchange-traded funds both represent baskets of securities (usually stocks or bonds, or both) and allow for instant and easy portfolio diversification.
{ 0 comments… add one now }