The Retirement Corporation of America

Learning Something About Bonds

THE BOND MARKET literally dwarfs the stock market. There are about 10,000 stocks with a total market value of about $5 trillion. But more than 1.5 million fixed-income investments trade with a market value of nearly $8 trillion.

True, bonds have had a mixed performance record over the years. From 1981— when inflation began to cool after being super-heated for several years and interest rates started falling—clear through 1993, bonds gave investors a handsome combination of interest and capital gains. And bonds outperformed stocks in 2000 and 2001.

But it's rare that bonds beat stocks for any length of time. Historically, going back to the mid-1920s, stocks have returned an average 12%, while bonds have only returned about 8%. That's one reason why bonds have gotten a bad reputation with many investors.

On the other hand, stocks are more volatile than bonds—three times as volatile, again going back to the mid-1920s. The worst year in history for intermediate-term bonds—those with maturities of between five and 12 years—was 1994, when they fell 5.1% in value. By comparison, in 1931, the worst year for stocks, investors saw the value of their equity investments fall 43.3%.

Still, bonds can be very volatile at times. In fact, prices of long-term bonds have risen—or fallen—as much as 30% in a single year. For investors who bought bonds for safety and stability, that was downright unnerving. Buy bonds for your portfolio—but understand the bond market before you buy.

What Bonds Are All About

Remember, that when you buy a stock, you are buying part ownership of the company whose stock you have bought. You share in the company's profits—assuming it is profitable. The more profitable the company, the more of those profits are paid to you in the form of dividends.

When you buy a bond, you are loaning your money to the issuer at a specified rate of interest for a specified period of time. The issuer may be anyone from the U.S. government or one of its agencies to your local school district. You have no ownership position in the borrower and no stake in its profits. You have the issuer's IOU to pay you that rate of interest over the life of the bond, and to return the money you loaned when the life of the bond ends, and it matures.

The bond market, which used to be pretty simple, has now become very complex. Long-gone are the days when all you had to do was buy good-quality bonds and forget them. Today, bonds range from the very simple like Treasuries to the very esoteric like some kinds of so-called zero-coupon bonds, which can be very good investments even though they don't pay you a penny of interest until they mature. And that's one problem with investing in bonds: the complexity of the market, which can perplex even fairly sophisticated investors.

Another problem is making certain you do earn the interest you are entitled to, and that you get your money back when the bond matures. When you buy a bond, you always have to worry about the issuer's creditworthiness. It might run into financial trouble and not be able to make some of your interest payments, or at least make them on time. Worse, the issuer could go bankrupt and you'd never get your principal back. Bonds are rated by a number of rating agencies. Bonds with the highest rating (AAA) are the safest, but pay the lowest rates of interest. Bonds with a lower rating (say BB) pay a higher rate of interest, but aren't as secure.

Investing in bonds—as in any investment—means seeking a balance between risk and return. Later in this lesson, you'll learn about bond ratings—who rates them and what the ratings mean.

Finally, there is that matter of volatility in the market. Just as stock prices fluctuate all over the place, so do bond prices. What causes bond prices to fluctuate? We'll get into that in more detail further on in the lesson. For now, just keep in mind:

•  When interest rates rise, bond prices fall.

•  When interest rates fall, bond prices rise.

When interest rates go up, a bond you own is worth less because investors can buy newer bonds paying higher rates. That sends the price of your bond tumbling. If you had to sell the bond that very day, you would have to do so at a loss. But when interest rates fall, the price of your old bond goes up. Its rate now looks more attractive compared with the lower rates on newer bonds. If you wanted to sell your bond that day, you could do so at a nice profit.

You must consider the volatility factor when you buy bonds. They tend to be more conservative investments than stocks, but they are far from risk-free.

Summing Up Bonds

So the bond market is more stable and less volatile than the stock market. But it isn't a piece of cake either. You could buy a bond you don't understand. You could buy a bond that doesn't repay your money. You could lose money if you had to sell a bond on a given day.

All things considered, that's why you don't want to buy any more bonds than you really need for good diversification.

Don't get the idea that bond investing is just too complicated and too risky to bother with, however. There are ways to minimize the risks of buying fixed-income securities. One of the main purposes of this lesson is to help you learn how to do just that.

In fact, this lesson will help you master everything you need to know about fixed-income investing step-by-step. We'll start off with some basics.