This article has been updated January 2014
Bonds are one of the cornerstones of the investment industry. They are an integral part of institutional money management and have an important place in retail investing.
What is a bond?
Technically a bond is just a loan where you lend the money and someone is willing to pay you back plus interest. The entity doing the borrowing might be the government in which we call it a government bond. The entity might also be a company which we call a corporate bond. You get a set rate of return for lending that money. This is often called the bond coupon.
Bonds have a maturity date which sets the term of the bond. At maturity, the original amount of the loan gets paid back.
Bonds can be bought and sold before the maturity date which means the price of the bond can fluctuate making them a little more risky than a Guaranteed Interest Certificate at the bank.
Are bonds safe?
As you can see from the risk return chart below, bonds are considered less risky than stock, Bonds, however are still not guaranteed. Bonds are interest rate sensitive so the performance will vary as interest rates change. When interest rates go up, bond values drop.
As you can see form the data below, bonds can fluctuate but not nearly as much as stocks.
Bond Returns vs. Stocks 1988 – 2014
Here are some other observations from the data:
- The biggest loss in bonds over the past 23 years has been −4.3% compared to −33% in the stock market
- Bonds don’t lose money nearly as often as the stock market (only 3 times compared to 8 times in the stock market)
- Bonds do not go up and down at the same time as stocks. They are what we call “not correlated.”
Two elements to bond returns
- Interest return. This is quite easy to understand. Bonds provide a fixed amount of interest for a certain period of time (known as the term of the bond). For example, if you have a 10-year bond that pays 5.0%, then the interest return is 5.0%. This interest could be paid monthly, quarterly, semi-annually or yearly.
- Price return. The more complicated part of the return is the fluctuation of the bond price. Bonds can be traded and sold at any time. As a result, the price of the bond can change. The main determinant of the bond price is interest rate movements. For example, if interest rates fall, bond prices will go up. If interest rates go up, then bond prices will fall. However, if you hold the bond to maturity, price return does not matter as much.
So, if you have an interest return of 5.0%, what could cause you to lose money? If interest rates start to rise, then the price of the bond will start to fall. If the price of the bond falls by more than 5.0%, then you will start to lose money. As you can see in the chart on the next page, the interest return plus the price return gives you the total return on the bonds. In the last 15 years, the price return on the bonds was negative four times and the total return on the bonds was negative only twice.
Bond returns 1988 – 2013 (Source:Morningstar,Paltrak)
|Year||Interest Return||Price Return||Total Return|
Long term bonds have greater price fluctuation
Generally speaking, the longer the term of the bond, the greater the interest rate you will get. However, it is also important to know that the longer the term of the bond, the greater the potential for fluctuation in price return based on interest rate movements.
In today’s economic climate, there is some concern that interest rates are more likely to rise than continue to fall. If this is the case, it may not be the best time to invest in bonds. Basically, the interest portion of the bond is low and does not give investors much of a cushion if interest rates start to trend up.
Regardless of timing, I'm not sure you should sell out of all your bonds because bonds will be an integral part of most people's portfolios so it's important to understand the basics of how they work.