It’s Whiteboard Wednesday time and, if you’ve been following along, you know what that means. That’s right, we’re smack-dab in the middle of The Investing Series, a beginner’s guide to investing, based on my book, Invest Like a Pro. If you’re just now joining us, you can catch up here.
Last week we talked about stocks and how, when you buy a stock, you become a part-owner in the issuing company. Today let’s look at bonds.
What Is a Bond?
When you buy a bond, you’re lending money to a company. To compensate you for the risks associated with the loan, the company pays you interest. (What if they go belly-up?)
For example, if a company issues a bond for $1,000 with 7 percent annual interest, that means you’re loaning them $1,000 with an agreement that they’ll pay you back, plus $70 per year, until the bond reaches maturity.
In this example, the principal of the bond is $1,000. The interest is your profit of $70 per year. The due date by which all principal and interest payments are due to you is called the maturity date.
So, say you’re holding the bond from our example, with 7 percent interest, and rates go up. Now you’re stuck with a 7 percent profit, while companies issuing new debt (bonds) are offering 10 percent. Ugh.
You could try to sell, but with a lower interest rate than the market, you’re probably not going to get back your full $1,000 principal. You can entice buyers with, essentially the equivalent of a 10 percent return, by selling for less than the principal value of your bond. To determine that amount, you would calculate how much the remaining principal and interest payments are worth.
The important thing to understand is that, if interest rates go up, bond values go down. If interest rates go down? Bond values go up!
So, in our example, if the market rate had dropped to 4 percent, your 7 percent return would look pretty good.
Last week we talked about index funds, a type of investment vehicle that holds a variety of underlying stocks. When you invest in a fund that holds many stocks, it won’t affect your investment as much if one of the stocks isn’t profitable.
The same principle applies to bonds. More variety means less risk, so you want bonds from a variety of companies—and, just like with stocks, there are bond funds that make it easy to diversify.
A Word About Risk …
Generally, bonds are less risky than stocks. They also, historically, provide a lower return. (Which makes sense. Investors are compensated based on the amount of risk they assume, so lower-risk investments typically pay less.)
Bonds are also less risky than stocks because, as a bondholder, you’re a creditor. If the company goes bankrupt, they’re still required to pay back their debt to you. If you’re a stockholder, as a part-owner of the company, your stock could potentially be worth nothing.
This is a very simplified explanation, and bondholders can still incur losses if a company goes under, but it illustrates why bonds are generally considered less risky than stocks.
Types of Bonds
So, very briefly, let’s look at the different types of bonds:
Federal Government: Government-issued bonds, like Treasuries (or T-Bills), are usually the least risky and most liquid—meaning they’re easy to sell. Investors buy more government bonds when the market feels turbulent because federal bonds are guaranteed.
Municipal Government: Municipal bonds are issued by state government and they’re also considered relatively safe.
Corporate: Corporate bonds are issued by companies and vary in quality. Bonds rated AAA are less risky than bonds rated A. A is less risky than C, and so on. If the rating is low enough on the scale, you’ll hear them referred to as junk bonds (because they are high-risk!). Remember, with more risk, you should receive a higher potential return.
What About Cash?
So, now that we’ve covered stocks and bonds, what about cash? Firstly, have some. The more the merrier. As you’re allocating your investment dollars, make sure you have a little bit of a cash position. This is above and beyond, obviously, any kind of emergency fund.
Next week, we’ll talk more specifically about investment vehicles.
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