Written by Andrew Roth
After spending nearly a decade in the financial services industry, both on the institutional money manager and advisory sides of the business, I still find that many people misunderstand how bonds work as part of a diversified portfolio. I thought I’d put together an article to address one of the most poorly understood aspects of finance—even among professionals.
Simplistically, a bond is a piece of paper representing a contract between a lender and a borrower. It represents a loan amount to be paid back in full at maturity, plus an interest rate to be paid periodically (the bond’s “coupon”). Bonds are then traded on the open market, changing hands at either a premium or a discount depending on how they compare to other similar investments, how close they are to maturity, and any risks associated with that borrower (i.e. “If Acme Corp. has borrowed $100 million dollars, how likely are they to pay it back?”). Bonds can be harder to understand than stocks because the factors that affect their value can appear counter intuitive.
Bonds play an important role in diversification and risk-management for people who cannot (or should not) stomach the volatility of the stock market. While an over-simplification, bonds have historically been “negatively correlated” to the stock market. Generally, this means when stocks have done poorly, bonds have usually benefited, and vice versa.
Think about an investment portfolio like a ship floating on the ocean. During rough seas that ship is going to rock violently if there is not enough ballast in the hull. Bonds in a portfolio are like a ship’s ballast. The ship may be slower during calm sailing but it shouldn’t rock and pitch as violently during heavy seas (and hopefully we don’t all get a sea-sick!).
One common question throughout my career has been “Why would someone invest in bonds when interest rates are already so low”? This is an intelligent question because it’s grounded by the general rule that the value of a bond goes down when interest rates go up. Essentially what is being questioned is the wisdom of buying bonds “if rates can only go up from here”? Following this train of thought, that would hurt the value of a bond investment.
Using the argument above, it seems that stocks would surely be a better investment than bonds regardless of investor situation during periods of already low interest rates.
My response would first be that no one knows exactly where interest rates are going to go next. Ten years ago, I don’t think anyone believed interest rates could decline any further, yet they have. Secondly, if we were to throw bonds out the window altogether, we’re left without good risk-mitigating options other than holding cash. While cash is important for financial planning, it’s a poor investment because purchasing power gets degraded by inflation. Adding to the defense of bonds, the potential risk of a high-quality bond portfolio during standard market cycles is still much less than that of your standard “blue chip” stock portfolio, even if interest rates do rise.
Furthermore, interest rates don’t rise linearly. There are dips and drops along the way. One of the reasons that our team believes so strongly in hiring active money managers to oversee our portfolios is that these active managers can take advantages of these dips and drops to hopefully maximize opportunities.
Finally, if the borrower is financially sound, it is assumed that the lender will get paid back in full at maturity. This means that regardless of how a bond’s value fluctuated throughout its life—at the end of the day if $1,000 was loaned, $1,000 will be paid back. Active managers can hold bonds until maturity if they find it prudent.
I’ve only scratched the surface of what mechanics affect bonds and their prices, but hopefully this has helped to clarify something that is normally as clear as mud.
If you need to get some fresh air after reading this, I don’t blame you!