Many stocks pay dividends, but over the long haul stock investors
generate most of their return from price appreciation—the change in the
price of the stock. Bonds don’t work that way. Their prices will change, but
most investors choose bonds because of their interest payments. Because
issuers pay back the bonds at the end of their term, also known as maturity,
bond prices tend to revert to the face value of the bond as the maturity date
nears. Assuming an investor purchases a bond, collects the interest
payments, and then recoups the face value of the bond at maturity, the
changes to a bond’s price along the way don’t mean anything.
Unlike stock prices, which tend to fluctuate based on economic and
company news, bonds respond mostly to interest rates or changes in a
company’s perceived credit risk. If a company reports a strong quarter with
higher-than-expected profits, the stock price might rise while the bonds
remain steady. But if the company announces it has borrowed a lot of
money and credit analysts begin to doubt its ability to satisfy its obligations,
the company’s bonds could lose value.
Bond prices react to changes in interest rates because their fixed
payments look more attractive when interest rates fall and less attractive
when rates rise. For example, suppose Acme Widget issues $1 billion in 10-
year bonds at 5% during a period when the 10-year Treasury yields 3.5%.
Since investors can collect a 3.5% yield without risking default, Acme’s 1.5%
higher interest rate serves as compensation to investors for absorbing the
credit risk. If Treasury yields rise to 4.5%, the appeal of Acme’s bonds
declines; investors demand more than 0.5% for taking on the credit risk of
the corporate bond. As a result, Acme’s bonds likely dip in price, possibly to
a point where they yield roughly 1.5% more than Treasury bonds. The
reverse would happen if Treasury yields declined—Acme could lower its
rates accordingly and still be seen as a risk worth taking.
Long-term bonds tend to react to changes in interest rates more strongly
than do short-term bonds. Remember, bond prices tend to revert to par
value as they near maturity. A bond that matures in three months won’t see
its value change much even if interest rates migrate, because in three
months the issuer will redeem it for its face value. But a bond that matures
in 20 years—and has 40 semiannual coupon payments to make before
maturity—will react more violently to changes in interest rates, especially
as investors reprice the bond to take into account its yield relative to the
market.
Pros:
Steady income. Bonds appeal to investors who seek an income
stream from their investments. While many stocks pay dividends,
few deliver the yield investors can receive from bonds.
Safety. While bond prices do fluctuate, they don’t gyrate with the
same regularity as stocks. In general, bonds are considered safer
than stocks.
Diversification. Bonds offer substantial diversification benefits
when paired with stocks in a portfolio. Because bonds tend to take
their cues from interest rates rather than the economy or the stock
market, they often move in a different direction than stocks.
Cons:
Low returns. Over long periods of time, bonds tend to
underperform stocks.
Trading difficulty. While the bond market is massive, it lacks the
transparency of the stock market. Investors can’t just check on the
price of their bonds at the Yahoo! Finance website and make
instantaneous trades. Discount brokers don’t buy and sell bonds at
all, and investors seeking to purchase a bond generally must either
go through more expensive brokers or contact the bank that makes
the market for that bond.
Complex analysis. Bond analysis hinges on assessing an issuer’s
creditworthiness, a task few people have the training to do well.
Most individual investors get their bond exposure through mutual
funds, allowing professional credit analysts to do the legwork.
Bonds As a Currency.
