July 23, 2024
Hello, everyone! Welcome back. You're watching another episode of Money Fundies. My name is Matt Stearns, and we're here at Millennial Money Management. If you missed our last episode, we were talking about stocks, mutual funds, and ETFs, the role they play in a portfolio, how they differ from each other, and the different fees. So, check that out if you missed it.
Today, we're going to be going over the bond portion of the portfolio, how that differs from the stock portion, how bonds function, and how they relate to different moves in the marketplace. Understanding the difference between a bond and a stock is very fundamental. When we talk about stocks, we're talking about ownership of that particular company. That's one of two ways that a business can raise capital to finance its capital projects. The other way is the more traditional route, which is to go get a loan from a bank or from the public, and that is precisely what a bond is.
A bond is essentially you, being the investor, issuing a loan to the company. The company says, "Okay, we need two million dollars. We want to go to the public and issue these bonds with a particular interest rate." So, they might issue 2,000 bonds at a $1,000 price, paying 5% interest. You, as the bond investor, get paid interest annually. In a lot of cases, it's semi-annually, but we'll just use a simple example for now. They'll say it's good for 10 years: give us $1,000 for this bond, and in ten years, we'll give you the $1,000 back. Each year, we'll give you 5%, which will be $50.
So that's what makes an investment good for the creditor, which in this case is the investor, where the public acts as opposed to the bank. When we own bonds, we're essentially acting as a lender for these companies. We're acting as though we're a bank. These companies also go to banks for private monies, for private loans, but when they need extra, they go to the public market. This is one of the ways that companies finance themselves.
Now, bonds can also come from governments — local, state, and federal. You can buy bonds from other countries' governments and capital businesses that want to raise money in the free market. So, that's the first part of understanding what a bond is. It's essentially debt; you're becoming the creditor for that company.
The second part is understanding how bonds function in the secondary market. When we begin to talk about bonds, we talk about an interest rate and a price. As I mentioned before, we'll use the price of $1,000 and 5% interest. That is what we call the coupon rate — the introductory rate — and that is set for the life of the bond. No matter who owns that bond, they're going to get paid 5% interest, in this case, $50 a year because we have a $1,000 bond.
However, once that bond goes to the secondary market for the remainder of those ten years, say the person who bought it initially, since that interest rate can't change, the price becomes negotiated. A number of factors affect the quality of a bond — the same sort of credit qualities that affect an individual. How much total credit is this company utilizing? How much are they growing? How healthy is their balance sheet? How are interest rates moving, as the federal government sets them? So, we have a lot of factors that affect the price of a bond, and the only thing that can change is that price in the secondary market when you go to buy and sell it before the bond timeframe expires.
As I said, once those ten years are up, whoever owns the bond at that time is getting the $1,000 back. Let's say, for example, that the Federal Reserve raises interest rates. When interest rates go up in the marketplace, it makes your interest rate from perhaps a few years prior look less valuable. Since we can't negotiate the interest rate on the bond, the price gets negotiated. So, since our interest rate is lower than the new bonds that were just issued, it makes our bond price less valuable. The bond might sell for $900 compared to the original $1,000 because someone can go out into the marketplace and pay $1,000 for a new bond with, say, a 6% interest rate. That’s how bond prices move.
So, what does this mean for an investment portfolio? Well, it means a couple of different things. One, when we hold bonds in an investment portfolio, they don't have quite the extreme price reaction to market volatility as stocks do. Stocks have the potential to swing rapidly, 10% or more, or even crash by 50% or more in some cases, whereas bond prices usually don’t fall as rapidly. There are different market factors affecting bond prices, so they are generally a little less volatile and have less downside potential, which also means less upside potential. However, we get the consistency of owning the interest rate. No matter what happens to the price — it can be going up and down throughout the entire time you're holding a bond — you're going to get $50 no matter what. And if you hold it for the 10 years, you're going to get $1,000 back. It doesn’t matter what happens in between.
These are all things to consider. Bonds give us consistent interest payments and a little more consistency in our portfolio. We usually talk about bonds as part of a portfolio for someone nearing retirement or growing older, to offset the volatility of stocks. Realize that we're also limiting upside potential, but it’s about reducing volatility and increasing consistency. That’s one of the key roles that bonds play in an investment portfolio.
Understanding that as interest rates go up, bond prices move in the downward direction, so it moves inversely. That’s another key takeaway. Bonds are a necessary part of most investment portfolios. You’ll find them in 401(k) plans, and hopefully, you now understand a little bit more about what they are, how they respond to market movements, and how we can utilize them in investment portfolios.
That’s all for today. If you have any questions or want me to go over anything else in more detail, I'd be happy to do that. For now, that’s all I have for you. Thanks for joining us! I hope to see you again. Please like, comment, or subscribe below, and we'll see you next time. Thank you
