One of the biggest determinants of how risky and rewarding your portfolio is falls upon how you distribute your money between stocks and bonds. Historically, bonds offer far more stability and they have held their value better during downturns. This makes them a better option if you prioritize capital preservation. On the other hand, stocks have historically offered higher returns in the long-run. There are more bumps along the way, but stock investors do expect a higher return to compensate for the added volatility. This makes stocks a better option if you can handle volatility and desire portfolio growth. Why exactly are bonds considered safer and stocks considered higher growth? Below you will find answers to that question. Much of what you see will be a review from previous readings; however, we will delve deeper into each concept so you can fully understand what you are getting into.
Bonds represent the debt of a company or government. First they are issued, and then the general public has the option to purchase them. The money that people use to purchase newly issued bonds goes directly to the issuing company or government, and the borrower then uses it to fund projects. You have no ownership. You are simply loaning your money to them. In return for your loan, you expect to one day be paid back the original money that you loaned them. This is called the principal. Additionally, you expect to be paid interest every year as a reward. After all, you’re not just going to give them your money for free.
How Do They Work?
Bonds are fixed income securities. That means that in the beginning, you know what you are getting into. For example…
You purchase a bond for $1,000. It promises to pay you 5% interest every year and matures in 5 years. This is what the payments would look like:
|Year 0||Year 1||Year 2||Year 3||Year 4||Year 5|
As you can see, in year 0 you purchase the bond and have an expense of $1,000. After that, you get paid 5%, or $50, each year for the next four years. The bond matures in year 5. At that point, you earn your final interest payment ($50) plus your initial investment ($1,000). The price of the individual bond can change over time if you want to sell it early, but if you hold for the duration and the issuer fulfills their obligation, you know exactly what you’ll make up front. In our example, you know that you are set to make a 25% return, or $250, over the course of 5 years.
How Safe Are They?
You know what your return will be up front ~if~ the issuer does not default on the loan. How big is that “if”? Obviously, when you loan out your money, there is always the risk that the entity you are loaning to does not pay you back. If you loan some money to a friend, they can always skip town the next day and you never hear from them again. I guess that person probably wouldn’t be a friend anymore. Companies, and even governments, can also leave you high and dry. Luckily, there is a lot more regulation and accountability in every step of the process when you loan to large entities. Anything can happen, but let’s review the order of expected stability when it comes to bonds.
1. Government: The US Federal Government has an excellent track record of making good on its loans. They are largely considered to be “risk-free” and are widely believed to be the safest investment. Bonds from foreign governments, as well as bonds from the state and local levels, may carry a little more risk. It is very situational, but government bonds are generally considered to be the safest overall. For this reason, you will also find the lowest reward. They pay relatively small interest.
After that we get into corporate bonds. Luckily, there are rating agencies to help us determine the safety and stability of bonds.
2. Investment Grade: These corporate bonds come highly rated. They are believed to have a lower chance of defaulting. They are typically companies that have great track records when it comes to paying off debt. They can also have excellent cash flow and a fair amount of assets. These are the types of things you look for when trying to find a good candidate to loan money to. All in all, these can be a little riskier than the safest government bonds, but they are among the most reliable in the corporate world. The interest rate that you get as a reward is moderate.
3. High Yield: These corporate bonds have low ratings. They have a higher chance of defaulting. They likely do not have a great track record of making good on their debts. They also may not be earning much cash or have ownership in a ton of assets. For these reasons, they are not the most attractive candidates to loan your money to and they have the highest chance of defaulting. In order to attract investors, they offer the highest interest rates. They are undoubtedly the high risk and high reward investment when it comes to bonds.
What does a default look like?
Let’s imagine that a company runs into trouble and their profits and revenues plummet. For the sake of the example, let’s also say they don’t have a lot of cash saved up. Suddenly, they realize that they may have a problem making good on their bonds. What do they do?
The first thing they can try is borrowing more money to pay off current debt. However, their predicament is most likely public knowledge. They will most likely have trouble finding anyone who will loan any money to them at any reasonable interest rate. If no one is loaning to them, they can try to sell off assets and stock to raise cash. However, if they need to sell quickly, they will most likely have to sell at “fire sale” prices and get little cash for their efforts. They are in a real pickle.
This can happen to any company. However, as you may imagine, a lot of the time it is not going to be completely unforeseen. Most likely, the company will already be rated “high yield” and there has already been cause for some concern. No matter the situation, they simply cannot pay their obligations. What happens next?
When a company defaults on their loans, it often leads to bankruptcy. That is usually not good for anyone involved. They are going to have to restructure the business, which means they will sell off assets that they own. It can also mean a change in ownership and management, many employees laid off, and just an overall ugly situation. What is the silver lining if you’re a bondholder?
In bankruptcy, there is an order in which investors get paid back during the restructuring. Creditors (bondholders) are toward the top of the list. That means that as the company tries to salvage value, they will use the proceeds to pay back the creditors first and foremost. Essentially, when the issuer of the bond defaults, they are at the bondholder’s mercy. You trusted them to borrow your money, and they have a debt to you. On the opposite end of the spectrum, the stockholder is the last to get paid back. During many bankruptcy events, the stock of the company can very easily be worth nothing, while the bonds have at least some salvage value. Could bonds still be worth nothing? If the company is in a big enough hole, absolutely. But it is fair to say that the bondholder is simply in a better position during events like this.
With all that in mind, you can be fairly certain that the businesses you loan to are going to make you a priority. Even if they do fail, you are not completely rolling over.
Are There Any Other Risks?
I’m glad you asked.
Changing interest rates can change the current value of the bond. The concept of changing rates can get pretty complicated, so we will try to keep it as simple as possible to drive in our main point. In the US, the federal reserve decides what interest rates should be and how they change over time. If people can buy an identical bond that pays more interest for the same price, your bond becomes less valuable. Let’s look at this example…
Let’s say you purchase a treasury bond from the US government that will mature in twenty years. It costs $1,000 and pays you 5% in interest every year.
Over the course of the next ten years, it pays you some nice interest. However, in that time, interest rates have changed.
Now investors can purchase a treasury bond that matures in 10 years, costs $1,000, and pays you 10% interest every year. Interest rates have gone up dramatically. After holding a 20-year treasury bond for 10 years, your bond will also mature in 10 years. It has the same issuer. It is also supposed to pay you back $1,000 principal in ten years. It is exactly the same in every way, except your bond only pays 5% interest. Why would someone pay you $1,000 for a bond that yields 5% when they can get the same one that yields 10%?
Your bond is worth less. To be exact, your bond is worth $750 today. Don’t worry too much about the math. Just understand that when interest rates rise, the current value of already issued bonds tends to go down. Changes in rates are unpredictable.
Because of this, be cautious of the amount of time until maturity. Short-term bonds are less affected by changes in interest rates because they mature much sooner. Even if there is a massive jump in interest rates, short-term bonds will mature quickly and you will earn back your principal investment. You can then immediately use that money to invest in higher yielding bonds if you so choose. There is not much drama at all. If you buy a long-term bond and rates change, you could have to wait decades to benefit from new higher rates. That makes them far less appealing. However, do not fret. Longer term bonds aren’t all bad. They typically pay more interest than short-term bonds to reward you for tying your money up longer. Also, if interest rates go down, the present value of longer-term bonds will likely go up. A lot. When all else is equal, your 5% treasury bond is worth more than an identical, newly issued one yielding only 3%. At the end of the day, it all goes back to your time horizon and risk-tolerance. For more potential stability, choose higher-grade, shorter-term bonds. For more potential growth, choose lower-grade longer-term bonds. And of course, you can always go somewhere in the middle or diversify all over the place!
One Final Risk?
Perhaps the most overlooked risk to bondholders is the risk of inflation. Inflation eats away at the spending power of money. As time goes on, products and services tend to get a little bit more expensive every year. If everything costs 3% more next year, a 2% gain could actually be considered a loss. With that in mind, investors may want to add a little more volatility to their portfolio. Whether it is riskier bonds or holding some extra stocks, you can try to offset some of these invisible costs.
What is the Best Way to Buy Bonds?
For most individual investors, the best way to purchase bonds is probably through bond funds. Even if you want to take a more active approach in your portfolio, you probably want to pick stocks instead of bonds. Bond ETFs make it easy for investors to get broad or targeted exposure to bonds. For broad exposure, you can simply choose a total bond market fund which gives you ownership in a small piece of thousands of different bonds. To target something specific, you can choose a fund that only owns short-term treasuries, long-term high-yield bonds, or anything in between. These bond funds have several advantages.
1. Low Fee: Purchasing an individual bond can have steep transaction costs, and they can also be complicated to trade in and out of. Many bond ETFs offer an extremely low management fee and trade at high volumes. That means that buying and selling them can be as easy as trading the stock of a large company, and you will end up saving a lot on transaction costs.
2. Diversified: By choosing a corporate bond ETF, you may be loaning your money to thousands of different companies. This diversification reduces risk, as it is far less likely for thousands of companies to default on their loans compared to one individual business facing hard times. That assurance may add a level of comfort and allow you to take a little more risk.
3. Monitored and Managed: Sometimes an investment-grade bond is deemed more risky by a credit rating company. That leads to a downgrade and it can become high-yield. In five years, long-term bonds may become medium-term bonds, and short-term bonds will mature and become cash. The investment company will make sure that the holdings within the ETF you are buying match the goal they set. That means that if you want exposure to short-term investment-grade bonds, they will monitor the fund for you. They will sell bonds if they fall below investment grade, as well as reinvest any cash earned back into bonds that fit the mold. You choose the ETF you want, and your money will continually target the exact bonds that you want. If you decide you want to shift your strategy, you can simply sell out of that ETF and move into another one. It is that easy.
That’s pretty much how bonds work. If you save money, you can loan it out to people that need it. For that, they will pay you more money. It is a really great system because it gives savers the ability to not have to work for every single dollar they earn. In fact, bonds play a huge role in many people’s retirements. Most bond funds pay out monthly income, and retirees depend on these payments to survive. Not only can you achieve this passive income through loaning out your money, but you can also build income streams through owning equity in businesses.
That brings us to stocks. How do they compare to bonds?
Do They Offer Fixed Income?
No. There is no guarantee of income.
Do They Have Ratings Agencies That Grade Their Riskiness?
What Do I Get If The Company Goes Bankrupt?
Most likely nothing or very little.
Yeah. You’re right. The process certainly isn’t as clean as simply buying a bond. After all, if you loan someone money, it is pretty straightforward. What is in it for you and what are the assurances that you will get paid back in a timely manner? You have to look a lot deeper when you are considering buying a company.
So, Why Do People Buy Stocks?
A lot of reasons:
- They represent actual ownership in a company. When you buy a stock, you are getting a piece of their income, assets, expected growth, and debt. All of that goes into the value of the share you purchase. Based on those things, if the price of a stock is clearly too low, people will buy it and the price will go up. If it is clearly too high, people will sell it and the price will go down. With that in mind, an investor can feel fairly confident when buying a stock that the price is fair based on all current available information.
- Publicly traded companies have a board of directors that take an oath to act in the best interest of the shareholders. They want to fulfil their obligation to bondholders, but they want to make stockholders rich. Many of them work tirelessly with the goal of growing revenue and profit. The best path is not always clear and poor decisions can lead to downward spirals in share price. However, you can be sure that it is their job to fight for you to the best of their ability.
- Historically, as a whole, stocks have consistently had better long-run returns than bonds. According to investment researcher Morningstar, stocks have delivered an average return of 10% per year since 1926, whereas long-term government bonds have only delivered 5-6% returns. Compounded over time, that 4% creates unimaginable gains. All of that being said, anything can happen. Stock prices go up and down a lot, and past returns are no guarantee of future performance. We only look to get an idea of how the market has historically acted.
At the end of the day, stocks simply are not as black-and-white as bonds. That leads to more speculation and volatility, which can be scary. Simply remember the three points that we are always talking about.
2. Spread your money out and invest over time
3. Reduce risk as you get closer to needing withdrawals
The ball is in your court and it is totally up to you to make investment decisions. Remember, your portfolio is not the only thing to consider. It is simply one part of your financial well-being. In addition to building a portfolio, you may also want to…
- Pay down debts
- Save an emergency fund
- Purchase real assets
- Advance in your career
- Start a side hustle
- Start a business
- Invest in yourself (Education, health, etc.)
All of these things and more can be part of the equation that gets you where you want to go! Keep all of this stuff in the back of your head. A lot of people don’t.