How Bonds Work (and Why it Matters)

If someone asked you to fill in the blank on the following comment, stocks and _______, my guess is your answer would probably be “bonds.” They are an integral part of investing, building portfolios and our entire economic system. But what are they, how do they work and why are they important, especially now?

A bond is nothing more than a debt instrument issued by a company or entity such as a municipality. Stocks represent ownership and bonds represent leverage. Here’s how they work. Let’s say a company issues a $10,000 bond at a rate of 5% and the term is for 10 years. That means the bond will pay interest of 5% each year, for the whole ten years. If the investor buys it and holds it until maturity, nothing will change. You get the interest, and then at the end of the term you get your money back.

However, there are a few important things you need to know. First, some bonds are callable, meaning the company can come back to you during the period and give you your money back and be done. Second, different bonds come with different types of risk, depending on time frame, quality and overall health of those who issue them. Third, many bonds are not held until maturity, and this changes the trajectory of the entire discussion for most investors, especially in the current economic environment. Here’s why, explained through a fictitious story.

Let’s say I go down to the local “bond store” and buy a $1,000 5% bond. I have no plans to sell it until it matures. But then a few years later I need money to fix my car and must sell it. In the meantime, interest rates have gone up to 7%. So, when I go back to the bond store, I run into a friend who just bought his own bond. After catching up, I ask if he wants to buy my 5% bond. He says to me, why would I buy your $1,000 5% bond when I just purchased the same thing for 7%? He offers me $950 for it. I have to take a “penalty” from my purchase price so to speak. Hence, bond prices and interest rates run in the opposite direction. If rates had gone down, my same bond would have been more valuable because I was earning a higher rate than what was currently being offered.

So, why is all of this timely? Because, for most of the past 30 years, we have been in a declining interest rate environment. This means that when rates go down, bond prices go up. It has been a perfect environment for bonds. Now that we have finally changed direction and are seeing rates rise, we need to be considerably careful as it relates to our longer-term investing. This is something we have been fiercely concentrated on for the past twelve months and will continue to be moving forward. This entails understanding duration and shortening it, credit quality, bond type variations, and monitoring the economic outlook relating to all of this. We’re on it.

Investing involves risk. No investment strategy can guarantee positive results. Loss, including loss of principal, may occur. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax or legal advice. Keep in mind that current and historical facts may not be indicative of future results. Diversification is an investment strategy that can help manage risk within a portfolio, but it does not guarantee profits or protect against loss in declining markets.

This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. (C) Twenty Over Ten