What is a Bond, and How Does it Work?
Bonds are a type of debt issued by a company or government to raise money from investors. You’ve likely heard the word before in the context of pretty much any investing related conversation, along with stocks. So what is it that makes bonds different from stocks? And why would someone want bonds in their retirement account, or any investment account?
The basics about bonds
The easiest way to think about a bond is to think of a loan. When you take out a loan from a bank for instance, you are borrowing money from the bank. In exchange for receiving that money from the bank, you are going to have to pay it back with interest added. To the bank, this loan is an investment they intend to get back from you, with interest being the added bonus for the risk they took, along with the amount of time the money was out of their hands and in yours.
When a company or a government needs/wants to raise money, one option it has is to borrow that money. A bond is just a way for companies or governments to borrow money from investors. With a bond, the investor becomes the bank – receiving interest payments at a rate determined by the creditworthiness of the company or government and the amount of time before the money is paid back.
Generally, the better a company or government’s financial situation, the lower the interest rate an investor will demand to purchase a bond issued by them, and vice versa. Likewise, the longer an issuer is wanting to hold onto the money before giving the investor back their principal investment, the higher the interest rate will need to be, in most cases.
Since bonds are essentially just a type of debt obligation that pays investors a steady stream of income over time, in addition to their original principal investment (at maturity), bonds are typically considered much less risky investments than stocks.
However, with lower risk comes lower expected returns, especially over long periods. Historically, stocks have outperformed bonds over every single rolling 20-year period. But, returns are not the primary or even secondary purpose of holding bonds in a diversified portfolio.
Why would an investor want to include bonds in their portfolio?
Because of their lower-risk properties, bonds can help provide a buffer against volatility of other asset classes like stocks, in a diversified portfolio. As mentioned, bonds also provide a stream of steady interest payments to the investor, which can be very important to an investor that is either retired, or living off the income from their bonds for any other reason. Generally, as an investor gets closer to retirement over their career, they can benefit from increasing the amount of bonds in their portfolio. Doing so helps to preserve more of the wealth they’ve worked hard over the years to build.
By shifting more and more money from higher-risk investments like stocks, to lower risk investments like bonds, an investor’s portfolio becomes less volatile. This is important for someone nearing or already in retirement, when they are either not contributing to their portfolio anymore and therefore unable to benefit from stock market volatility, OR they are on track to meet their goals and no longer need to take the added risk of investing heavily in stocks in order to achieve long-term growth.
Investors that can benefit from holding bonds in their retirement portfolio:
- Someone that finds it difficult to stomach the short-term ups and downs of the stock market.
- Someone with less than 25 years until retirement (greater percentage of bonds over time as retirement approaches).
- Someone on track to meet or exceed their retirement savings goal with a lower risk portfolio.
- Someone that is already retired and/or needing bonds as a source of fixed income.
A simplified example of how bonds work
How does a bond work? Let’s say you have $10,000 to invest right now and are looking for something that will be low risk and provide a steady stream of income for the next 10 years. In other words, you’re looking for a 10-year bond!
You find out that a large company that’s been around for more than a century with a solid financial history is issuing new 10 year bonds at a 4% interest rate. This means that you will agree to give the company $10,000 today in exchange for payments of $400 per year for the next ten years. In ten years, the bond will “mature” and you will be given back your $10,000 initial investment.
Bond investing gets tricky and complicated when someone holding an individual bond needs or wants to sell the bond before maturity. For example, let’s say you decided to buy the above bond, but need to sell it just one year later. You need to find another investor to buy it from you. If the same company is now issuing new bonds at an interest rate of 6%, why would another investor give you the same $10,000 for a bond paying only 4%? They wouldn’t. They would only be willing to buy the bond from you at a discount from the original “face value” of the bond.
This is known as interest rate risk and it can get very complicated. The basic thing you need to know is that as market interest rates increase, the price an investor is willing to pay to purchase an existing bond decreases, and vice versa. Luckily, it’s not as relevant to investors holding bonds in a retirement account…
How does this apply to my retirement account?
Retirement accounts like 401(k)s offer a menu of investment options for employees (participants) to choose from. These investment options are most often known as mutual funds. A mutual fund is a type of investment that owns hundreds or thousands of stocks and or bonds, and sometimes other things. Like a stock mutual fund, someone purchasing a single share of a bond mutual fund is effectively purchasing a diversified bond portfolio that owns a fractional piece of hundreds or thousands of individual corporate and/or government bonds.
The benefits of broad bond diversification are similar to those of stock diversification. Mainly, holding many different individual bonds isolates the investor from the downside of any single bond issuer (company or government) defaulting on their bond.
Bond diversification also means that bonds in the mutual fund’s portfolio will likely be maturing on a regular basis, which gives the fund manager the ability to always be purchasing new bonds at current interest rates. This practice of reinvesting in newly issued bonds helps mitigate the interest rate risk mentioned above.
Why bonds can be an important piece of your portfolio
Risk is one very important factor that we actually CAN control, to some extent, as investors. Bonds won’t eliminate all risk, but can reduce overall risk in your portfolio. That said, there are many different types of bonds and some can be considered riskier than some stocks at times. In general though, bonds tend to give investors a way to reduce overall risk to their portfolio, while still being able to invest in riskier assets like stocks. While bonds will likely reduce your portfolio returns when the stock market is doing well, they will also act as downside protection when stocks decline, as they do fairly often.
While a portfolio containing bonds will likely underperform one comprised entirely stocks over the long-term, the returns will likely be more steady and consistent, the more bond exposure you have. This can be very important to an investor’s ability to stick to their long-term strategy through thick and thin. Ultimately, the amount of bonds anyone should hold in their portfolio depends on their age, time until retirement, and comfort with risk, also known as risk tolerance.
Make the switch to Blooom
Now that you know what a bond is and how it works, allow our team of experts to help guide the way to an optimized portfolio with Blooom. Sign up today to improve the allocation of your account and get ahead of the financial curve. Have more questions? We’ve got you covered! Contact us today and get the answers you deserve for a better financial future!
The information is provided for discussion purposes only and should not be considered as advice for your investments. Investing involves risk. Your investments are subject to loss of principal and are not guaranteed.
Published on November 25, 2019