Let’s pretend that you are remodeling a deck at your house and you are $250 short on funds required to complete your project. You casually mention this fact to your brother who has been helping with construction. He offers to loan you the $250 if you will invite him over when you grill on your new deck a few times this summer, and that you can repay him the $250 within the next few months. You both agree to the terms as described, and you borrow the money and finish the project. This type of arrangement is generally what happens in the world of bonds. Corporations, governments, and municipalities often need money to finish projects, fund operations, or expand their presence, so they turn to investors to raise money.
Previously we discussed the concept of issuing stock to raise funds for corporate use. When a bond is issued, an entity borrows money from investors and agrees to pay interest at set intervals over a certain amount of time. Those variables (interest rate, payment schedule, when bond matures) must be known upfront by investors and are generally set for the life of the bond.
Bonds have some distinct traits that stocks do not possess.
- Bonds have a narrow range of outcomes. Since the return parameters are known in advance, the bond issuer will be forced to follow those promises or will otherwise default. Investors can protect themselves from the risk of default by investing in higher quality corporate bonds, municipal bonds, or US government bonds, for which the likelihood of default is extremely remote. In the event of a bankruptcy, bond holders are first in line for the assets of the company whereas equity (stock) holders are at the back of the line. Bond holders may be fully repaid while equity investors find their shares of stock to be worthless.
- Bonds provide a steady, known stream of interest payments over the investment period. For individuals looking for retirement income with predictability, bonds can play an important role in achieving these goals.
- Certain types of bonds are treated as tax-free income (municipal bonds). This can prove very beneficial, especially for investors in higher income tax brackets who are looking to minimize taxes paid on their investment income.
Bonds have a couple of risks that are somewhat unique to them.
- Bonds have higher inflation risk. As the overall risk level in bonds is lower than it is for stocks, the return potential is also less. As prices rise for goods and services (inflation), investors must be able to outpace these rising prices. This is an inherent challenge for bondholders, and an important point that we will come back to at the end.
- Bonds have reinvestment risk. All bonds must eventually end and be repaid by the borrower. There are some companies and governments that have issued 100 year bonds, and some bonds are for less than 1 year. In either case, they are eventually repaid which means investors must find something else to reinvest the money into. If interest rates remain stable, this will not pose a problem to the investor. However, if interest rates were to move up or down in more significant fashion, investors may not have the same future opportunities as they look to reinvest their funds as they did originally. Stocks do not expire, so investors are not forced to look for other opportunities on a set timeframe as they are with bonds.
Bonds can certainly play an important role in an investment portfolio. We like to think of bonds as a way to avoid being a forced seller. When someone retires, they begin to have an immediate cash need from their investment portfolio. Stocks are less predictable and more volatile than bonds, yet offer a higher potential investment return over time. If an investor has enough invested in bonds to cover their spending needs for 3-5 years, then when periods of declining stock prices arrive investors are not forced into selling stocks at a poor time.
Overall, bonds may allow investors the capacity to earn a higher overall rate of return in retirement, as they afford the investor much needed patience and flexibility during a time of required portfolio withdrawals.
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