Stock market volatility has a way of returning when investors least expect it. A particularly volatile period can wipe away trillions of dollars in wealth (on paper) in a matter of days. In its wake, dazed, confused, and anxious investors are left wondering if things will only worsen.
But some investors can't stomach the vicious ups and downs of the stock market and don’t trust stocks at all. They want less risk and anxiety while growing and protecting their money.
Instead of stocks, they invest in bonds issued by corporations, governments, cities, towns, and even their local water authority. How do bonds work? They guarantee these investors a fixed rate of return, or “yield.” It’s basic, and far more predictable than other assets.
How Do Bonds Work?
For both the private and public sectors, issuing bonds to investors raises capital to grow a business or finance construction of, say, a new road or ball field. Folks who buy and hold bonds — called bondholders — earn agreed-upon interest payments for a fixed “maturity” period that may end after a few months or several decades.
Some bonds even pay in perpetuity. In fact, the oldest known bond in the world, issued by a Dutch water authority in 1624, is still paying holders 2.5 percent interest each year.
Why Do Investors Need Bonds?
Investing all your money in stocks is a risky decision. Bonds are a crucial member of any investment portfolio, in part to hedge (or diversify) against those times when stocks’ value takes a nosedive out of the blue.
In other words, when stocks yin (drop), bonds yang (stay calm).
The maturity period on most bonds ranges from one to 30 years, and bonds typically pay three to four percent interest payments annually. There are some bonds that pay a little bit more and risky bonds may even pay double-digit interest.
Some investors buy bonds not just to diversify their investment portfolios, but also to profit off a rise or fall in a bond’s trading price. Others will hold their bonds to maturity so that they can get back their entire principal (initial investment). That safe guarantee of repayment, along with interest payments, makes bonds a top pick for many investors.
Most rich people stash their wealth in bonds, not stocks. They don’t need to take risks in order to get rich — they just need to preserve their wealth.
Are All Bonds the Same?
Bonds contain differing levels of risk and yield. Riskier ones pay more in interest than those that are less risky.
Bonds generally come in three classes: corporate, government, and municipal. There’s also a rarely used fourth type of bond the late great musician pioneer David Bowie successfully sold himself — “Bowie Bonds.” He managed in short order to raise $90 million, financed by his royalty stream.
Most investors don’t buy individual bonds. Instead, they access hundreds of different bonds when they buy mutual funds or exchange-traded funds (ETFs).
How Do the Bond Classes Differ?
Corporate bonds attract those who don’t like risk, even though it can get them a higher yield.
Government-bond investors buy what are called “Treasuries,” which are low risk and carry a low rate of return. This is how our beloved federal government raises money to run itself.
Meanwhile, state and local governments issue municipal bonds to help raise money for public works and such. Generally speaking, bondholders don’t have to pay federal or state taxes on the interest payments they receive on these.
What Are the Downsides of Bonds?
You can make more money investing in stocks, but you need to take on investment risk. Risk is a fact of life. But bonds give us a cop-out. That can hurt risk-averse investors who keep all their money in bonds, thus missing out on the returns stocks offer.
Plus, if the issuer of the bond defaults (or refuses to pay on the bond), you’re screwed. An extreme example (and cautionary tale) is the collapse of Puerto Rico’s municipal bonds. Thousands of investors lost their life savings when the government defaulted. Though for the record, the number of defaults by corporations and governments are low.
Poorly managed businesses and governments aside, bonds are a must-have for any investor. They can provide steady, low-risk income for years to come, which is especially handy in retirement.
Plus, you can lower your taxes each year by investing in some municipal bonds issued by cities and states. And bonds as a portfolio diversifier can provide the best antidote against the volatility that inevitably sweeps through the world’s stock markets.