What Are Bonds, and How Do They Work?

How Bonds Protect You From the Next Recession

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Back in the old days, investors owned actual paper copies of corporate bonds. Photo: Stockbyte/Getty Images

Definition: Bonds are loans made to large organizations. These include corporations, cities and national governments. A bond is a piece of a massive loan. That’s because the size of these entities requires them to borrow money from more than one source.

The borrowing organization promises to pay the bond back at an agreed-upon date. Until then, the borrower makes agreed-upon interest payments to the bondholder.

In the old days, when people held paper bonds, they would redeem the interest payments by clipping coupons. Today, this is all done electronically.

Bonds are usually resold before they mature at the end of the loan period. That's because there is a secondary market for bonds. The value of a bond rises and falls. 

Advantages

Bonds pay off in two ways. First, you receive income through interest payments. Second, you can receive payment if you resell the bond. Of course, if you hold the bond to maturity, you will get all your principal back. That's what makes bonds so safe. You can't lose your investment unless the entity defaults.

But you might be able to get more than your principle back. Sometimes bond traders will bid up the price of the bond beyond its face value. That would happen if the net present value of its interest payments was higher than alternative bond investments.

That would be especially attractive if it was highly unlikely that the company issuing the bond would default on its debt.

In that case, you might do well to sell the bond, pocketing the profit. In most of these cases, the company issuing the bond would recall it. The firm would reissue debt at lower interest rates.

Unless the enterprise defaults, you are highly unlikely to lose money on a bond. That's why they are a safer form of investment than stocks.

 

Like stocks, bonds can be packaged into a bond mutual fund. That's a good way for an individual investor to let an experienced mutual fund manager pick the best selection of bonds. A bond fund can also reduce risk through diversification. This way, if one entity defaults on its bonds, then only a small part of the investment is lost.

Disadvantages

Over the long haul, bonds pay out a lower return on your investment than stocks. In that case, you might not earn enough to outpace inflation. Investing only in bonds might not enable you to save enough for retirement.

Companies can default on bonds. That's why you need to check the bondholder’s S&P ratings. Bonds and corporations rated BB and worse are speculative. That means they could very easily default. They must offer a much higher interest rate to attract buyers. The highest paying and highest risk ones are called junk bonds

For many people, valuing bonds can be confusing. That's because bond yields move inversely with bond values. In other words, the more demand there is for bonds, the lower the yield. That seems counter-intuitive. Why would investors want bonds if the yields are falling? Because bonds seem safer than stocks.

What Bonds Tell You About the Economy

Since bonds return a fixed interest payment, they tend to look more attractive when the economy and stock market decline.

 When the business cycle is contracting or in a recession, bonds are more attractive.

When the stock market is doing well, investors are less interested in purchasing bonds, so their value drops. Borrowers must promise higher interest payments to attract bond purchasers. That makes them counter-cyclical. When the economy is expanding or at its peak, bonds are left behind in the dust.

The average individual investor should not try to time the market. You should never sell all your bonds, even when the market is at its peak. That's when you should add bonds to your portfolio. That will provide a cushion for the next downturn. A diversified portfolio of bonds, stocks and hard assets gets you the highest return with the least risk. Hard assets include goldreal estate and cash.

When the economy contracts, investors will buy bonds and be willing to accept lower yields just to keep their money safe.

Those who issue bonds can afford to pay lower interest rates and still sell all the bonds they need. The secondary market will bid up the price of bonds beyond their face values. That means the interest payment is now a lower percentage of the initial price paid. The result? A lower return on the investment, hence a lower yield.

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