Bonds Are Safer Than Stocks
One of the biggest misconceptions in investing is that bonds are a safe investment. This misunderstanding likely stems from people hearing that bonds are SAFER than other investments like stocks and translating that to mean safe. In reality, bonds can be very volatile, but there are some features that can make them much less risky than stock based investments.
A bond is basically an IOU from an entity. There are corporate bonds, government bonds, and municipal bonds. Each is just another form of borrowing from investors.
The way a bond works is that the investor loans the entity money by buying a bond. So, technically, the $1,000 paid for a bond isn’t so much a purchase, as the amount lent to the company. If the company does not dissolve or declare bankruptcy, the investor will get that $1,000 back at the end of the bond’s term.
What make bonds a worthwhile investment is their interest payments. Again, as long as the company does not dissolve or declare bankruptcy, the investor will receive guaranteed payments of interest on the bond. This makes bonds a great way to plan for income needs.
So, where is the risk?
Many bonds have terms of several years, some as long as 20 or 30 years. If the bondholder keeps the bond the entire time and the company does not go bankrupt, then the investment is indeed safe and predictable. However, in the time until the term of the bond expires, the price that the investor can sell the bond for will go up and down.
A bond’s price will decline if interest rates rise and vice versa. Furthermore, if the company’s perceived strength increases or decreases, the value of the bond will likewise rise or lower. What this means is that regardless of the security of the eventual payoff of interest and principal, the number on an investor’s statements will rise and fall just like any other investment.
Another difficulty in understanding the safety of bonds is that unlike individual bonds which are held by the investor, bond mutual funds are not in the investor’s control. That means that losses may be locked in by the fund selling the bonds at a lower value than they were acquired for before the term of the bond expires. This removes one of the big safety features of bonds.
While bonds are generally considered a less volatile investment than stocks, they are not safe over the short term. And, as the financial collapse has shown us, even big seemingly strong firms can and do go bankrupt overnight causing bondholders to lose their principal.
Bonds should be an important part of most investor’s portfolios, but they are not for money that must be kept “safe.”