Have you ever marveled at someone who is absolutely calm in the face of chaos?
Captain Sullenberger, the US Airways captain who landed his failing plane in the Hudson River, is probably the greatest recent example of that…
Or Muhammad Ali, leaning back against the ropes in Zaire while 60,000 fans screamed and George Foreman – one of the hardest punchers in boxing history – threw murderous punches at his head and body.
All the while, Ali knew Big George would tire himself out. The Greatest would get him shortly after…
Their cool and focused minds led to the best possible outcomes in what looked like dire situations.
In a diversified portfolio, that is the role that bonds assume.
Owning bonds in a portfolio provides ballast for when times get rough – like we’ve seen in the past few weeks.
Some people may think bonds are boring. After all, what’s exciting about buying an investment, getting paid 5% or 6% per year, and then getting your money back when the bond matures? There are stocks out there returning 100% or more!
True, there are stocks that rocket higher. Plenty of them fall too, especially in this type of market.
Owning bonds where the company is legally obligated to give you your money back at maturity and pay you a fixed amount of income twice a year adds stability to your portfolio and your income.
If you’re unfamiliar with the difference between a stock and a bond, it’s quite simple.
When you buy a stock, you become an owner in the business. The stock price can move up or down substantially based on the perceived value of the business. You’re also entitled to dividend payments if management decides to pay them.
When you buy a bond, you are lending money to a company – you are not an owner. If you buy the bond in the open market, you’re not actually the one giving the company money. Instead, you are buying the credit that the company must pay back.
Under the terms agreed upon when the bond is issued, the company will pay a specific interest rate twice a year. And it will pay back the $1,000 per bond on a specified date.
When you buy the bond, you may pay more than $1,000 or less than $1,000. If you hold the bond until maturity, you’ll take either a gain or a loss depending on the price you paid.
Here’s how it all works…
Let’s say you pay $950 for a bond with a 5% “coupon.” The coupon is the interest rate on the original $1,000. That means you’ll collect $25 twice a year ($50 total) until the bond matures.
You’ll actually earn more than 5% because you paid less than what is called the bond’s “par value,” or $1,000. You’ll collect 5.3%, because $50 divided by $950 equals 5.3%.
When the bond matures, the company will pay you $1,000, so you will make an extra $50 gain. Remember, you paid $950 and received $1,000 for the bond.
As with a stock, while you hold the bond the price can fluctuate. It can move higher or lower, but here’s the big difference…
With a stock, there is no maturity date. You’ll get paid only what the market is willing to give you at the time you sell it.
If you own a bond, it’s true that if you sell it in the open market you will get paid the market price at the time. But you can (and in many cases, you should) hold the bond until maturity when you are guaranteed to receive $1,000.
The only way you will not get the $1,000 per bond is if the company goes bankrupt, which happens rarely.
That guarantee is why we keep bonds in a portfolio. While stocks are crashing, we know that at least a portion of our portfolio will pay us a specific amount on a specific day.
While your portfolio may feel like Muhammad Ali’s ribs while Big George was pounding away, remember that Ali’s calm and focus allowed him to be victorious.
Owning bonds is a great way to stay calm while others are panicking. In this market, bonds are more necessary than ever.