by Cassandra Laymon, CFP®, MBA
Our next installment in this month’s series asks the question, “What is a bond?”
The first thing this brought to mind for me is the assumption that many people make when they reference being invested in “the market.” We use that term so frequently that some people believe that if they have money invested somewhere – in an IRA or a 401(k) or any investment account – that they are invested in “the market.” Let’s clarify. The “market” is our casual term for the stock market. When you watch that arrow go up or down on the news, that generally only reflects how stocks are performing. (If you missed it, you can read “What is a Stock? here.)
If you are invested in bonds, this portion of your investments is not in the market at all. Let’s start by defining a bond. A bond, at the most basic level, is a loan made to a company or government. I’ll use the analogy of a mortgage, since that’s something we’re all familiar with. When you buy a house for $250,000, it’s unlikely that you have the full amount of cash saved up. Perhaps you’ve saved up $50,000 for a down payment, then you take a loan out for the balance from a bank. They give you the $200,000 for the house, but it comes at a price. Over time you will not only pay them back the $200,000, you will pay interest. If they did not loan you the money, they could have done something else with it. (This is called opportunity cost).
In this case, let’s say you are going to pay them 5% and you pay back the loan and interest in 30 years, or 360 monthly payments.
Loan amount: $200,000
Interest @5%: $186,511
Total paid: $386,511
The bank made an extra $186,511 because they loaned you the money.
That is very much how a bond works, except in this scenario, you (the investor) are the bank! Bonds typically come in $1,000 increments and pay a certain percentage of interest that comes to you monthly, quarterly, or annually.
One big difference in how a mortgage and a bond works: a bond pays only the interest over time, and then when the time is up, you get all of your original principal back at once (provided the company hasn’t failed to pay for some reason).
Returning to our cupcake shop example from previous weeks, here’s how a bond works (note that small companies don’t normally issue bonds, but it will illustrate how bonds work):
After some deliberation, when your friend approaches you about investing in her cupcake company, you decline. You love the cupcakes and believe that your friend can really do well, but you don’t want to take on that kind of risk. Instead, she issues you ten $1,000 bonds, you give your friend $10,000 with the agreement that she will pay you 5% interest for 5 years. Over that five years, you will receive $1,323 in interest payments. At the end of the five years, she owes you the $10,000 back.
Bond amount: $10,000
Interest @5%: $ 1,323
Total paid: $11,323
Why would someone choose to invest in bonds? First, many people enjoy the idea of a fixed and steady income stream. In fact, bonds are called “fixed-income” investments. Here’s another attractive point: if your friend goes out of business but there is some money left to be distributed, such as the sale of a building or other inventory, you will get paid first. The stockholders never get reimbursed for their losses.
I believe this is a compelling case for owning bonds, or mutual funds that invest in bonds. (Read What is a Mutual Fund? Here.) Now, I must come back to our biblical principle on diversification. We don’t want to be invested all in stocks or all in bonds – we want to spread that out so when one thing isn’t working well, there are other investments to balance it out. In fact, it is often true that the stock market and the bond market move in opposite directions. That means that when stocks aren’t doing well, bonds probably are, and vice versa. This does not mean you’ll never experience a loss, but it will feel like less of a roller coaster ride when there are wide swings in the market.
I hope this series has compelled you to know what you own! If you have any confusion when looking at your statements and need assistance in understanding what you are invested in, don’t hesitate to contact us at email@example.com.
Financial Planning & Investment Advisory services offered through Beacon Wealth Consultants, Inc.