Many people who invest have a clear picture of shares: you own a small piece of a company, and if it does well, so do you. Bonds are much less familiar, and much less talked about, even though the bond market is larger than the stock market. If you own only shares, this guide explains what bonds are, how they behave and why most long-term savers end up owning some.
A bond is a loan
When you buy a bond, you lend money to a government or a company. In return, they promise to pay you interest at a fixed rate, called the coupon, usually once or twice a year, and to return the original amount on a set date, called the maturity.
For example, a ten-year government bond of $1,000 with a 4% coupon pays $40 a year for ten years, then returns your $1,000. If the borrower keeps its promise, you know exactly what you will receive and when. That predictability is the whole point.
Shares are for growth. Bonds are for sleep.
Priya Raman
Why bond prices move
Bonds can be bought and sold before they mature, and their prices change every day. The main reason is interest rates. Suppose you own that 4% bond, and interest rates rise so that new bonds pay 5%. Nobody will pay full price for your 4% bond when they can buy a new one paying more. The price of your bond falls until its return matches the new rate.
The reverse is also true. When interest rates fall, older bonds with higher coupons become more valuable, and their prices rise.
Different kinds of bond
Not all bonds carry the same risk.
- Government bonds from stable countries are considered very safe, because governments can raise taxes to repay them. They usually pay the lowest interest.
- Corporate bonds are issued by companies. They pay more, because companies can go bust.
- High-yield bonds, sometimes called junk bonds, are issued by riskier companies and pay much more, with a much higher chance of not being repaid.
- Inflation-linked bonds adjust their payments with inflation, which protects your spending power.
Why hold bonds at all?
If shares have historically grown faster, why hold bonds? There are three good reasons.
- They often steady a portfolio. In many market falls, high-quality bonds hold their value or rise while shares drop, softening the blow.
- They provide income. Regular coupon payments are useful for people who need to draw money from their savings, such as retirees.
- They match future needs. If you know you will need a certain amount on a certain date, such as a house deposit in five years, a bond maturing then can be a sensible match.
Bonds do not always move opposite to shares. In years when inflation rises sharply, both can fall together. But over long periods, a mix of the two has usually given a smoother ride than shares alone.
How ordinary savers own bonds
Most people do not buy individual bonds. They hold bond funds, which own hundreds of bonds at once, or they hold them inside a pension or a mixed fund that combines shares and bonds. Many pension funds automatically move money from shares into bonds as retirement approaches, reducing risk when there is less time to recover from a fall.
What the yield tells you
When people talk about bonds, they usually talk about the yield, not the price. The yield is the return you would get if you bought a bond at today's price and held it until it matures. When bond prices fall, yields rise, and the other way round. They are two views of the same thing.
Yields also say something about the economy. When investors expect interest rates and inflation to stay high, long-term yields tend to rise. When they expect a slowdown, long-term yields often fall, sometimes below short-term yields. Economists watch that unusual pattern, known as an inverted yield curve, closely, because it has often, though not always, come before a recession.
Bonds and inflation
Ordinary bonds pay fixed amounts, so inflation eats into their value. This is why bonds had a very difficult time when inflation rose sharply. Inflation-linked bonds were created to solve exactly this problem, and many investors hold some of both.
The bottom line
Bonds are not exciting, and they are not meant to be. They are the part of a portfolio that is supposed to behave well when the exciting part does not. If you own only shares, it is worth asking a simple question: if the market fell by a third next year, what would you need to be doing in the meantime? The answer often points to some bonds.
