What would you guess is the hardest investment class for most people to understand?
You might think it's stocks, or a subclass of stocks like those of companies in emerging markets. Or how about real estate investment trusts (REITS) that hold various types of investment real estate. Maybe it's commodities or complex alternative investments like managed futures or long/short funds.
While all of these have varying levels of complexity, I find the most difficult asset class to explain is bonds.
Even the name "bond" is confusing. It's not intuitively descriptive like real estate, commodities, or even stocks. Here is the big difference between bonds and all these other investments: With stocks, real estate, and commodities you own something. You own a tiny slice of a company, a piece of real estate, or a commodity like gold, oil, or grains. You don't buy these things primarily to receive income. While companies can pay small dividends and real estate can throw off rent, the real reason for owning financial investments is appreciation, the hope they will increase in value over time and can be sold at a profit.
Conversely, when you own a bond you have effectively made a loan. Even calling a bond a "loan" can be confusing. Most people don't relate to a loan as being something to invest in, because most of us equate a loan with being a borrower. Maybe the best way to describe this asset class is as "lending." A bond is a loan where you are the lender, not the borrower. Owning a bond is the same as owning a loan in the context that someone owes you money.
The main reason someone makes a loan is to receive income, what we call interest. We don't make loans with any anticipation they will go up in value. We make loans to get a steady stream of interest payments for a specific period of time, at the end of which the borrower will give us our dollars back. Like other loans, a bond has an interest rate the borrower has agreed to pay you, a payment schedule, and a term or a period of time that will pass before the loan is either paid off or becomes due.
It may sound confusing when we talk about buying a bond because when you buy a bond you are buying a loan. The company or government that wants to borrow money creates a debt obligation with an interest rate and terms, a bond. They then offer these bonds on a public market where you can buy them, or where a mutual fund in which you invest can buy them. Your money goes to the company, and the evidence of their debt to you—the bond—is registered in your name or the name of the mutual fund in which you invest.
There are two reasons why it's important for investors to understand bonds. First, the bond market is five times larger than the market of stocks. Second, it isn't unusual for a balanced and diversified portfolio of asset classes to include over twice the percentage of bonds than US stocks.
Bonds are issued by both governments and corporations, and different types of bonds will perform differently as investments in various economic scenarios. The right mix of domestic and international bonds can help cushion the blow of rising and falling stock markets, interest rates, and inflation.
Next week we'll take a closer look at different types of bonds and the way they work as investments. Even though they may be hard to understand, bonds belong in the portfolio of almost every investor.