The low down on bonds

While bonds aren’t the attention-seeking headliners in a young person’s investment portfolio, it has a specific diversifying role. So, we want you to be informed on the fundamentals. Read on for some money sentences to drop into casual conversation…

Setting the scene... A bond is an I.O.U. from the borrower (typically a corporation or the government, yes, you can loan money to the gov) to you (the investor). When you “buy a bond” you lend your money and, in return, expect interest payments. This contrasts with “owning” a little of a corporation through stocks and benefitting from its stock price growth.

Q: I don’t understand how bonds work...

We’ll breakdown the who, what, and how for you:

WHO (are you lending money to)

There are 2 entities that issue (sell) bonds to you and us:

1. Corporations — mysteriously called Corporate Bonds

2. Governments — called Treasury Bonds (US gov), or Municipal Bonds (your local state or city, to fund new park)

WHAT (are the jargons you hear)

Face Value / Par Value: The original for-sale price of the bond.

Price: This fluctuates with overall US interest rates.
🗣If you want to impress in an interview: you can quote the price of a bond by saying it’s trading either “above” or “below par”.

Interest/Coupon: What you earn for lending your money.
🗣If you want to impress at a 4th of July BBQ: “Isn’t it interesting that a bond’s price and current interest rates have an inverse relationship? If interest rates on newly issued bonds went down (like now!) then the price of existing bonds locked at higher rates go up!”

Yield-to-Maturity: What you expect to earn on a bond if it’s held to maturity (e.g. a “10 year bond” = you lend your money for 10 years). On investing platforms, you’ll see this quoted annually and as a %.

Credit Quality/Bond Rating: A score given to bonds based on how likely you’ll earn your interest and the loan is paid back. Sounds familiar? JUST like your credit score that lenders give YOU. So notice a bond’s rating before you buy. Scale goes from AAA (SUPER secure investment) to D (you might as well just give the money to a friend). High risk high reward though. AAA ratings come with lower interest rate, but lower rated “junk bonds” pay you much more (if they end up paying).

HOW (do you make money from bonds)

1. Hold the bond until maturity, and collect the periodic interest payments.

2. Sell them at a price that's higher than your face value (what you paid initially).

Q: So should I buy bonds or stocks?

Both - for that balanced diet. This is the energy bonds bring:

Stability: A guaranteed stream of interest payments — which you can turn around and invest in the stock market (#ballermove). To be clear, “guaranteed” unless the company or government went bankrupt.

Safety: As the less-risky friend to invite along to round out the party. People use them to decrease overall portfolio risk. But low risk-low reward right? So the gain with bonds is not the biggest.

Tax Relief: Anytime the gov wants you to do something (like donate to charities, save for retirement) they let you do it tax free. Similarly here, if you buy Treasury or Municipal Bonds (lend to the federal, state, or city gov money), the IRS won’t collect taxes from the interest you earn.

Just as we chat ETFs for stock...enter our favorite thing ever - Bond ETFs! No reason to go buying individual bonds.

💡Pro Tip: A rule of thumb for how much of your portfolio should be bonds vs. stocks is to subtract your age from 100. If you are 20, then 80% of your money should be in stocks and 20% in bonds. A very conservative rule, but a great starting point!

Did we convince you of the sexiness of bonds? It may not read like this month’s issue of GQ, but if you’ve made it this far, you clearly have your eyes on the real prize.