Stocks and bonds are the basic building blocks of our portfolio. Think of stocks as the offense and bonds as the defense. Bonds are basically loans to a government entity or company that are paid back over time. Depending on how creditworthy the borrower is and how long the borrower will take to repay the loan, bonds can be relatively safe investments, or carry more risk. The two big factors that help investors classify bonds are referred to as quality and maturity.
Just as some individuals are seen as better borrowers, so too are governments and companies. Those borrowers who are considered more or most likely to repay a loan in full are charged the lowest interest rates and are considered the safest borrowers. Borrowers who have a greater risk of defaulting on a loan are charged a higher rate to compensate for that risk. When you buy a bond and become a lender, it’s important to think about who your borrowers are.
Bonds issued by the U.S. government are generally considered the most secure because the government has never missed a payment. As a result, U.S. government bonds pay investors the lowest interest rates. The low risk is met with a commensurate reward.
On the other end of the spectrum, bonds issued by companies or governments with a higher risk of defaulting are charged higher interest rates by their bondholders. While these higher interest rates can be attractive, the value of these bonds can fluctuate as much as stocks during an economic recession. Bondholders also risk this type of bond ending in default, meaning that the company or government never repays the full amount of the loan.
Investors can purchase bonds that will be repaid in as little as a few weeks, or as long as 30 years. Longer-term bonds carry greater risk because there’s more uncertainty about what will happen farther in the future. The shorter the term of the bond, the lower the risk, which means the investor is paid a lower interest rate.
How Merriman Invests in Bonds
Bonds are uncorrelated to stocks and typically don’t increase in value. The main benefit of bonds is to provide a counterweight to stocks when there is a downturn in the market. In the past, when interest rates were higher, investors would look to bonds to provide a steady and predictable income stream inside a portfolio. But today’s bond market is very different than the bond market your grandparents remember. Investors are often surprised to learn that bonds can lose value. Bond prices and interest rates are inversely related, so if interest rates increase after you purchase a bond, the price of your bond will drop. That’s a compelling reason for why we hold bonds – not for appreciation, but to mitigate risk and provide stability in the portfolio. The bonds we choose are high quality and have short-to-intermediate maturities.
The previous post in the series can be found here.