Perhaps no asset class is as lingo-loaded as bonds. Fixed income, rising
(or falling) yields, junk bonds, Fed tightening, TIPS, spreads, mortgage-backed
securities – there’s no shortage of jargon for this supposedly “boring”
investment that most of us own in our portfolios.
Bonds are admittedly complicated, and it’s easy to feel intimidated or
confused by what’s happening in the news. Fortunately, you don’t need to be a
numbers geek to be an informed investor. So let’s get past the industry-speak
and focus on what you really need to know about bonds.
What are they?
My BlackRock colleague Matt Tucker regularly explores bond basics. In
short, bonds are loans that investors make to governments, companies, pools of
mortgage owners or many other types of issuers. In exchange for your money, the
borrower promises to pay back the principal at maturity, with regular interest
payments along the way. That interest income is a bond investor’s primary
source of return, although bond prices can also appreciate or decline in the
marketplace.
One important concept to understand is yield, which is the annual income on
a bond, based on its market price; it’s sometimes used interchangeably with
“interest rates.” Matt recently took a closer look at yield when discussing
yield curve basics.
Today, yields are exceedingly low. In Germany, for example, some government
bond yields are negative, meaning that investors are actually paying the
government for the privilege of lending it money. U.S. yields are somewhat
higher – around 1.9% for 10-year Treasuries – but the big question for bond
investors right now is, how much higher they might go?
Why do people invest?
Investors look to bonds to meet a number of key financial goals. These are
the top three:
Diversification. This should always be on everyone’s list. Bonds help serve
as a true diversifier to a stock portfolio, meaning they almost always react
differently to economic and financial conditions. If you go back to 1926 (88
years), stocks were negative in 24 calendar years. Bonds were negative in only
two of those years. That divergence can help smooth out your overall returns,
and add a cushion when stocks go down.
Income. The regular interest payments of bonds have historically provided a
steady stream of investment income. With yields so low, however, investors have
had to think differently about how to source it, either by taking on a little
more risk or investing in bond funds that specifically target income.
Capital preservation. Bonds – specifically core, high-quality, intermediate-term
bonds – have been significantly less volatile than stocks, making them a good
anchor for your portfolio. Diversifying across different types of bonds can
further help manage risks such as inflation, rising rates and default
implosions, which can hurt bond prices.
How do I get in?
Most investors should own some bonds, at least for diversification. And
investors have a wide field to choose from, whether it’s through actively
managed bond mutual funds or low-cost exchange-traded funds (ETF), or a combination
of both.
How much, how many and what kind will depend on your own risk tolerance,
financial circumstances, goals and so on. This is a great conversation to have
with your advisor or someone else you trust.
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The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by myself, D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
The Jacksonville Business Journal has ranked D2 Capital Management in the top 25 of Certified Financial Planners in Jacksonville. The Firm is also a member of the Financial Planning Association of Northeast Florida, the Jacksonville Chamber of Commerce, the Southside Businessmen's Club, and the Beaches Business Association.
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