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Are Bonds a Safe or Risky Investment?

Posted By Jim On 07/13/2011 @ 7:01 am In Investing | 7 Comments

You’ve probably heard of the 120 minus your age [3] diversification rule: subtract your age from 120 and that’s how, as a percentage of your investments, much you should have invested in stocks. The rest should be in bonds. The idea behind that rule is that stocks are “risky” and bonds are “safe.” Are bonds really any safer than stocks?

At it’s core, a bond is a simple instrument. You are basically buying a debt instrument and loaning a company or municipal government or some other entity some money. The bond has terms like a regular interest payout (coupon rate), a life span, and a par (face) value. The bonds are themselves guaranteed by the entity that issued them and riskier entities typically offer higher interest rates to offset the risk that the entity defaults.

As you’d expect with any financial instrument, there are all sorts of variations on this general theme. For example, there are bonds that let the issuer “call” them, or pay them off, early. There are zero coupon bonds sold at a discount to face value (so you pay $80 for a $100 bond, get no interest, but you get $100 when it matures).

So does that make them riskier or safer than stocks?

Price Fluctuation

Since bonds are like any other security, many (but not all) are traded on the open market. If you buy a bond with a par value of $100 and the issuer faces credit issues, you may find the bond has lost its value on the open market (as other bondholders sell their bonds, fearing a default). If you hold the bond to maturity and the issuer can pay, they will pay you the face value of the bond ($100).

What affects the price of bonds? A lot of things. The two biggest factors are the issuer and the market climate. Bonds rely on the issuer’s ability to make the regularly scheduled interest payments and the final face value payment when the bond matures. Issuers facing credit problems, like many companies did during the credit crisis, will find their bonds are worth less and less as bondholders get concerned about the issuer’s ability to pay.

The market climate is another big factor because investors are always thinking of where they should be investing their money. As investors move into more bonds, bond values increase. As investors move out of bonds, bond values decrease. As interest rate increase, bond values decrease since alternatives might offer higher yields. Bonds may seem simple, but they have just as many moving parts as the stock market.

Coupon/Interest

The coupon rate of a bond is set for the life of the bond. If you have a bond with a par value of $100 and a coupon rate of 10%, it will pay $10 each year. Unlike stock dividends, the bond will always pay $10 per bond unless the bond issuer defaults. The bond issuer can’t “change their mind” about the interest it pays because the bond is a contract.

When you combine the coupon rate, which is set based on the par value of the bond, and the actual price of the bond, which can fluctuate on the open market, you get a yield. A yield is the dollar amount of the coupon divided by the current market price of the bond. So, let’s say you have a $100 bond that pays $10 each year (10%). If the bond becomes more attractive and it’s price increases to $200, the yield drops to 5% ($10 on a bond that pays $200).

Default

Companies can go bankrupt and bondholders are often left holding the bag (though they are ahead of regular common stock shareholders and behind secured creditors), which is the biggest risk with bonds.

In the end, I don’t think bonds are any safer or less risky than investing in stocks. With the exception of Treasury bonds, which was backed by the full faith and credit of the United States (even that is tenuous given the debt ceiling talks), bonds aren’t necessarily safer. You should give as much time and energy in bonds as you do with stocks.

Do you think bonds are safer or riskier than stocks?


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