What Are Bonds, And Do You Need Them?

Bonds, aka “Fixed Income.”  They are investment options in your 401(k) or your education savings plan, and financial advisors talk about them all the time, especially when they talk about “asset allocation.” But what are bonds and do you need them?

Bonds are financial agreements between an entity, whether a company, or government, looking to borrow money and investors who are seeking returns.  If an entity wants to borrow money, one option is taking a loan from a bank, but those loans will be on the bank’s terms. Issuing bonds is a way for an entity to borrow money from investors on the entity’s terms.

Example: fictitious company Really Cool Watches is looking at the financial markets and interest rates and decides that if they can get a bunch of investors to lend them money, they can use that money to invest in a faster better smart watch.  So, they issue bonds, and the terms of the bonds are something like this:

If you lend us $10,000 for a period of 10 years, we will pay you 4% every year, and at the end of 10 years, we’ll give you your $10,000 back.

For some investors, this is a great deal.  Really Cool Watches is regarded as being financially strong, and it’s a reputable company that should (and I stress should) be around for the next 10 years.  And, if you look around at other available options like savings accounts, CD’s and money markets, it might be difficult to find an interest rate as attractive as the one Really Cool Watches is offering you. So you can collect your interest, take back your $10,000 in 10 years and move on.

This financial arrangement takes place in local governments, which issue what are known as municipal bonds, on the Federal level in the form of Treasury bonds, and in publicly traded companies everywhere in the world.  So, now that you understand what bonds are do you need them?

Most people think of the stock market when they think of investing. Stocks go up, and they go down, and are usually an indicator of the financial strength of companies and the economy.  Bonds can rise and fall in price, but they often do so in the inverse of the movement of stocks.  Often, when stocks decline, bonds rise because they are regarded by investors as being less risky.  But when stocks rise, bonds may fall in price to reflect the fact that stocks have a historically higher long term rate of return.  This stock/bond relationship can help smooth out returns in portfolios over time.  Generally, greater the amount of bonds you have, the more conservative, or less risky, is your investment portfolio.

Investors usually invest in bonds in funds, which are professionally managed portfolios of many bonds. Young people with long time horizons generally need less bonds in their portfolios because they do not need current income in the form of bond interest rates, and because they can ride out the ups and downs of stocks over long periods of time.  Older investors cannot expose their savings to wide market swings, and bonds zig when stock zag, so they help manage risk.  Additionally, these investors can benefit from bonds’ current interest income, which they can reinvest in their portfolio or take as income.

Whether or not you need bonds is a decision you will reach with your financial advisor.  Now that you know a little bit about what bonds are and how they work, your eyes won’t glaze over the next time you hear about fixed income and asset allocation.

Paul T. Murray