The financial media, and sadly my own industry, love “insider speak.” Care for some liquidity premiums with your alpha? While it’s true that people often use cryptic language to show off, just as often it’s simply a case of forgetting that there are those in the world who don’t live and breathe the markets.
Perhaps no asset class is as lingo-loaded as bonds. Fixed income, rising (or falling) yields, junk bonds, Fed tightening, TIPS, spreads, mortgage-backed securities – there’s no shortage of jargon for this supposedly “boring” investment that most of us own in our portfolios.
Bonds are admittedly complicated, and it’s easy to feel intimidated or confused by what’s happening in the news. Fortunately, you don’t need to be a numbers geek to be an informed investor. So let’s get past the industry-speak and focus on what you really need to know about bonds.
What are they?
My colleague Matt Tucker regularly explores bond basics for The Blog. In short, bonds are loans that investors make to governments, companies, pools of mortgage owners or many other types of issuers. In exchange for your money, the borrower promises to pay back the principal at maturity, with regular interest payments along the way. That interest income is a bond investor’s primary source of return, although bond prices can also appreciate or decline in the marketplace.
One important concept to understand is yield, which is the annual income on a bond, based on its market price; it’s sometimes used interchangeably with “interest rates.” Matt recently took a closer look at yield when discussing yield curve basics.
Today, yields are exceedingly low. In Germany, for example, some government bond yields are negative, meaning that investors are actually paying the government for the privilege of lending it money. U.S. yields are somewhat higher – around 1.9% for 10-year Treasuries – but the big question for bond investors right now is, how much higher they might go?
Why do people invest?
Investors look to bonds to meet a number of key financial goals. These are the top three:
- Diversification. This should always be on everyone’s list. Bonds help serve as a true diversifier to a stock portfolio, meaning they almost always react differently to economic and financial conditions. If you go back to 1926 (88 years), stocks were negative in 24 calendar years. Bonds were negative in only two of those years. That divergence can help smooth out your overall returns, and add a cushion when stocks go down.
- Income. The regular interest payments of bonds have historically provided a steady stream of investment income. With yields so low, however, investors have had to think differently about how to source it, either by taking on a little more risk or investing in bond funds that specifically target income.
- Capital preservation. Bonds – specifically core, high-quality, intermediate-term bonds – have been significantly less volatile than stocks, making them a good anchor for your portfolio. Diversifying across different types of bonds can further help manage risks such as inflation, rising rates and default implosions, which can hurt bond prices.
How do I get in?
Most investors should own some bonds, at least for diversification. And investors have a wide field to choose from, whether it’s through actively managed bond mutual funds or low-cost exchange-traded funds (ETF), or a combination of both. There are even new “smart” strategies designed to help reduce specific risks.
How much, how many and what kind will depend on your own risk tolerance, financial circumstances, goals and so on. This is a great conversation to have with your advisor or someone else you trust.