Uncommon Cents

A bond is a loan in which the bond holder (the investor) lends money to the issuer of the bond (possibly a company or a government agency). Bonds are issued when a bond issuer (the borrower) decides it needs to borrow money, and often their needs are such that a typical bank may not have sufficient capital to meet them.

Like any other type of loan, the issuer is expected to pay interest (known as the coupon) on the loan, and, again, like other types of loans, the loan is expected to be repaid over a specific amount of time (the maturity of the bond). A bond is considered to be a fixed income security–the amount of cash paid for the bond is “fixed”, meaning if the bond is held to maturity, the bearer of the bond gets that fixed amount back.

Again, like with other kinds of loans, the interest rate on bonds tends to vary. One of the reasons it varies is the rating of the issuer. If you are lending money to a borrower without the best credit rating, you would expect to get a higher rate of interest for taking the increased risk; conversely, if you are lending money to a borrower with great credit, you would be likely to get a lower interest rate. A government backed AAA rated bond is considered the safest of bond investments; these would be the types of bonds issued by the Government National Mortgage Association (GNMA), also known as Ginnie Mae. Bonds, like stocks, are often traded between investors, which can also affect their price and interest rates. When bond prices rise, their yield (the interest paid on them) falls, and when bond prices fall, their yield rises.

While there are a lot of similarities between bonds and stocks, there are significant differences as well. A bond is a debt; a stock is an equity (we will discuss stocks in a coming post). Someone who owns stock in a company is like a part owner of a business; someone who owns a bond is like a creditor. If you own the business (or a part of it) you are entitled to share in the performance of the company, typically through fluctuations in the stock price as well as dividends; if you are a creditor, you are entitled to interest on the amount you lent, plus the amount you lent.

Investors usually have some portion of their overall portfolio invested in bonds (for instance, I have approximately 25% of my total portfolio in bonds). This is due to bonds historically being less volatile than stocks, and often the bond market will do well when the stock market does not. In 2007, quality bond funds such as the Vanguard GNMA Fund Investor Shares and the Vanguard Total Bond Market Index Fund did markedly better than the S&P 500 (although both had positive returns for the year), illustrating the importance of having bonds in your portfolio. Bonds can provide you with income on a regular basis and help to smooth out bumpy rides in the stock market and in my opinion have a place in everyone’s portfolio.

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