Bonds 101 & Money Viking Cartoon

Here is a cartoon that captures the essence of what a bond is and why a person may want them as part of their portfolio. Typically bonds or bond funds are added to a portfolio to mitigate the volatility of the stock market.

What is a bond?

A bond is the opposite in a way of a stock investment. When you buy a share of a company through their stock, you are actually becoming a small owner of that company. In fact, if you owned the majority of shares then you would in a way own a huge stake in that particular company. So stocks are an “OWNERSHIP” investment. Bonds on the other hand are a “LENDING” investment. You are lending your money to either a company or government for a major project or capital purchase. For example, let’s say the government wants to raise money for a large infrastructure project. They could sell bonds to bond holders to raise the money. The money is initially used to build the project and then slowly paid back to the “LENDERS”/Bond holders over a specific period of time usually at a set interest rate.

Pros of Bonds

  • Returns are fixed. You receive a fixed rate of interest and your principal returned when the bond matures. You know exactly how much your returns will be at the beginning of the investment. Bonds are like a step up from a bank CD or money market account. They typically do not return historically as much as stocks over the long run, but they are less risky.
  • Less risky as opposed to stocks. Besides receiving specified investment returns, bondholders are paid first over shareholders in the event of liquidation.
  • Bonds have ratings. Unlike stocks, bonds are universally rated by credit rating agencies like Standard & Poor’s and Moody’s. This gives investors more assurance when picking a bond but you probably still want to conduct your own research and due diligence before investing. The highest rated bond is AAA, meaning there is a high probability of the bond being paid back at the promised interest rate on the promised date.
  • Less volatile. A bond’s value can fluctuate according to current interest and inflation rates but are generally more stable compared to stocks. Stocks can be a wild ride and one needs a long investment horizon typically.

Cons of Bonds

  • Less liquid. Bonds are generally less liquid compared to stocks, in other words you can’t always sell them really fast. You typically have to wait until the maturity date to get all your money back.
  • Exposure to interest rate risk. Interest rates affect the value of bonds more directly compared to stocks. If you plan on just receiving interest payments and holding the bond to maturity, this might not concern you.
  • Fixed Returns. With a stock there is a chance that the return could be much higher or lower, but on average stock returns for the S&P 500 are about 7-8%. With bonds you have a lower fixed return.
Some sample highly rated Bond Funds: Vanguard Total Bond Market Index Fund Vanguard VFSTX Short Term Investment Grade Fidelity Total Bond Fund FTBFX Fidelity Intermediate Municipal Income The great Jack Bogle of Vanguard investing uses a simple rule of thumb for his asset allocation over the years. Take 90 minus your age and that should equal the amount of money in a stock fund and the remainder goes in a bond fund. The idea is that a 30 year old would have 60% of money in stock funds because that young person has many years to ride out the ups and downs of stocks. An 80 year old on the other hand would only have about 10% of assets in stock funds and the remaining 90% in bond funds. This way they will not lose a ton of money in the years that they cannot afford huge swings in the market. I personally think this should just be viewed as a very rough guide and that each persons situation and risk tolerance is unique to them. People’s individual goals are also different. Some plan on spending every last dime on the day they die while others intend to leave a legacy and inheritance to their children.  

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