Let’s be honest. If there were such a thing as an “investor
toolbox,” bonds would be the weird looking wrenches that get buried at the
bottom. They come in many different sizes and shapes, each with a strange name
and specific purpose.

Conversely, stocks would be the hammer: simple and
intuitive. If the company does well, the stock goes up, and you benefit. How
much does a stock cost? Easy. Prices are quoted in dollars and cents; buying
stocks online or through a broker is relatively common. Bonds are not as easy
to value and less common to trade. But bonds can be intuitive once you cut
through the jargon and focus on the basics. Moreover, bonds are an important
component of portfolio construction that warrant consideration.

What is a bond?

When you buy a bond, you are effectively loaning your money
to a company, government, or other enterprise. To understand the basic mechanics,
let’s stick with a loan you make to a company, or a “corporate bond.”

When you loan your money to a company, you are entering into
an agreement with three key provisions:

                1) How
long until I get my money back?

                2) How much will the company pay
me to use my money?

                3) What
if the company can’t pay me back?

Maturity: When
you will get your money back, or the length of the loan, is specified in
advance. This is called the loan’s “maturity
date.”  If you buy a 10-year bond,
you are effectively lending your money to the company for 10 years. At the end
of 10 years, the bond “matures” and you get your initial investment back.

Interest: During these
years, the company will issue you payments in return for the use of your money.
These interest payments are
typically paid in monthly, quarterly, or semi-annual installments. How much
will they pay you? It depends. Intuitively, the longer you part with your
money, the more you are going to charge. You will demand a higher interest rate
for bonds with a maturity date that is further away.

You will also be paid more if you are less confident that the
company will be able to pay you back. An established company with blockbuster
sales and billions in the bank can borrow money at a very low rate of interest.
A start up with unproven products and nothing in the bank will have to pay much
more.  As with any investment, you should
expect a greater reward if you agree to take on more risk.

Default: One risk
is that the company fails – and can’t pay you the interest (or even the
original money you lent). In this scenario, the company has defaulted on their debt, and their assets
are sold off to pay investors. When the line forms to pay investors, bond
holders are at the front of the line and stock holders are at the back. In most
cases, stock holders don’t get anything until all the bondholders receive their
due. This “senior” status is a key difference between stocks and bonds.

Other Risks

When you buy a bond, you know exactly how much you’ll get paid, and when
(hence the moniker “Fixed Income”). Combined with their senior status in the
context of default, it is most often the case that bonds are less risky than stocks.
In general, this is the appeal of bonds: steady, predictable income with
relatively small movements in price.

However, bonds still have risk. Some of that risk is company
specific (as described earlier). There is also risk related to changes in the
bond market and overall economy. For example, if the overall level of interest
rates in the market moves higher, and your bond has a lower interest rate than
a comparable bond issued today, you miss out on the higher rate. If you decide
to sell your bond, investors will tend to pay less for your bond and gravitate
to the newer bonds with higher interest rates.

Inflation is also a risk. Say you buy a $10,000 bond with 10
years to maturity, and there is high inflation in the economy during that time.
When the bond matures and you get your $10,000 back, you won’t be able to buy
the same amount of food, haircuts, medicine, and gasoline that you could when
you purchased the bond. This effect is compounded if inflation has outpaced the
interest you earned on the bond.

The Bottom Line

Bonds offer several key benefits including diversification,
predictable income, and relative safety. They are indeed a useful tool to have
in your financial toolbox. However, bonds have their own risks that should be understood
and managed. These factors bear careful consideration and continuing diligence.
After all, failing to understand the opportunity and risks presented by bonds could
really throw a wrench into your plan.