During the last bull market, a newspaper editor I know became increasingly frustrated with his father, who stubbornly refused to add a single stock to his portfolio, which was 100% invested in bonds. At seventy-two, he simply wasn’t interested in doing a thing that might jeopardize his retirement savings. To him, bonds, bonds, and more bonds were the answer.
So what’s a bond?
Simply put, bonds are like IOUs. When you buy a bond, you’re essentially loaning money to the government or to a corporation. In return, you get regular income in the form of interest payments (thus the term fixed income) as well as the promise that your entire investment will be returned when the bond matures. In theory, if you buy a $10,000 bond that pays a 5% yield and matures in March 2009, you will receive annual income of $500 until March 2009, at which time the original $10,000 investment will be returned.
Notice that I said “in theory.” As a category, bonds fall somewhere between cash-equivalent investments (such as CDs or money market mutual funds) and stocks on the risk/reward continuum. In general, you get higher yields from bonds than from cash investments, but you don’t have the same potential for growth that comes with stocks. Depending on the bond you purchase (with U.S. government bonds on the safe end of the spectrum and riskier, higher- yield corporate bonds on the other), you also assume more risk with bonds than you do with cash investments. This includes the risk of default as well as the risk that rising interest rates will erode the bond’s value. Nonetheless, bonds are generally less volatile than stocks—provided they are high-quality issues that you hold until maturity. But if you deviate from this reliable strategy and start to trade bonds—or sell them prior to maturity—you are assuming a higher level of risk.