Why Buy Bonds?

Mention bonds and you usually hear ... silence. Bonds are rarely the topic of cocktail-party chatter, but what you give up in tales of amazing Qualcomm-like gains, you get back in steady income and all-important portfolio diversification.

Sound boring? Perhaps, but you can bet that when the market turns south, you will be pretty happy to have bonds among your investments.

Just about every investor should own bonds. Remember that the ultimate success of any portfolio largely depends on its mix of stocks and bonds and cash, not on the particular securities. It is true that, historically, bonds have returned less than stocks. Bond returns have averaged about 6 percent since World War II, while stock returns have averaged about 11 percent.

But it is also true that bonds and stocks tend to do well at different times in the economic cycle, so the bonds you hold will probably perform well just as your stocks hit a bad patch. That is why diversifying your portfolio helps keep your returns high over the long term.

Who Needs Them?

Along with stocks and cash, bonds are the third leg of your asset allocation. Standard wisdom holds that investors choose their allocation by subtracting their age from 100. The resulting number is the percentage of your assets you should invest in stocks, with the rest spread between bonds and cash. So a 30-year-old investor will have 70 percent of assets in stocks and 30 percent in bonds and cash, and a 65-year-old investor will have 35 percent in stocks and the rest in bonds and cash.

Most investors chose to increase their bond allocation as they age. After all, you don't want to lose your hard-earned next egg if you happen to retire during a bear market.

Many retirees rely on the income generated by bonds. Investors looking for income often buy bonds with a fixed coupon in order to have a predictable income during retirement. But bonds also make sense for younger investors seeking to limit their portfolios' overall risk and for those investing for short-term goals. You may, for instance, want to switch some of your child's college savings into bonds as she enters high school, or your down payment savings into bonds a year or two before you plan to buy a home.

How Bonds Work

Bonds may be safer than stocks, but they can get complex. Bonds are essentially IOUs. They represent the debt of the government agency or corporation that issues them. Every bond has a term, which can range from as little as a few weeks to as long as 30 years. When a bond reaches the end of the term, it has matured.

Bonds have a face value, which is the principal. You get that principal back when the bond comes due. Bonds also provide income by making regular payments (known as the coupon). Payments are made every six months, so if a bond has a coupon of 8 percent, it will pay two 4 percent payments. Those payments won't change, so bonds will provide a fixed income stream for as long as you hold them.

Beyond the income you will get from a bond, you can also make money if the bond appreciates during its term. The price of a bond is its par value. That value can change if interest rates change. If rates decline, your bond will increase in value and you can sell it at a premium. If interest rates rise, the bond loses value.

What kind of bond you choose depends on when you want the principal back and the return that you seek. As with all investments, risk and return go hand in hand. Bonds return less than stocks, but they are also less risky. Bond risk typically depends on the type of bond and the time until maturity, with the longer the term, the higher the risk and return. Treasury bonds, which are backed by the solvency of the U.S. government, are among the least risky investments you can own. Corporate bonds are a bit more risky, depending on their quality.

Now, find out how to choose the right bonds for your portfolio.

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