Zaks Investment Advisory Service

Bonds Basics and Different Asset Classes

We devoted our four previous programs to oil and energy-related problems. This is a very fascinating subject, but now we will switch to matters that are more prosaic, though no less important. We are going to talk about bonds. In a certain sense, bonds are more important to our economy than oil is: we spend about $400 billion a year on the purchase of oil, while more than $6 trillion in bonds are issued (and, correspondingly, bought) every year. (For reference: in 2006,the size of the bond market, i.e. the total value of bonds, was about $27 trillion. This is more than the value of the entire stock market.)

What is a bond? In our previous programs we talked primarily about stocks, so let us compare these two financial instruments. Companies issue bonds, just like stocks, to attract additional capital (bonds are used not just by companies – but more about that in a minute). Companies issue stocks when they initially enter the market (what is called an IPO, or an Initial Public Offering), or later on, issuing additional shares (secondary stock offering). When you buy shares of a certain company, you become this company’s partial owner. Suppose a company issues one million shares and you buy 100 of them on the market. You then become owner of 1/10,000 of that company. But when companies issue bonds, they are simply borrowing money. They could have just as easily gone to the bank, which some small companies do, but it is more convenient (and cheaper) for large companies to issue bonds. When you purchase bonds, you become the company’s creditor: the company owes you money. It settles its debt by paying back coupons (usually, the coupons are paid twice a year), and, upon reaching maturity, the bond’s face value. Bond’s differ from stocks in that they have a maturity date: theoretically, stocks may exist forever, i.e. as long as the company does. Bonds, on the other hand, have an absolutely determined lifespan. These spans may be different, but usually stretch from one to 30 years. Similar short-term financial instruments, with a lifespan of up to one year, are called “money market instruments.” These include such instruments as Treasury bills and certificates of deposit.

Who issues bonds? Bonds are issued by companies (corporate bonds), our federal government (Treasury bonds), various government agencies (federal agency bonds), states and municipalities (municipal bonds), and different private and government financial institutions that issue bonds to finance mortgages (mortgage-related bonds). Bonds are bought by both private investors and various financial companies (for example, pension and investment funds, banks, etc.)

Where are bonds traded? The predominant majority of the trading occurs between brokers-dealers and major financial organizations on the so-called over-the-counter market (rather than the major exchanges). A very small part of corporate bonds are bought and sold on the New York Stock Exchange. Individual investors buy specific bonds fairly rarely, although as I have just said, it is possible. More often, they buy shares of bond mutual funds, i.e. shares of investment companies that invest in various bonds. Thus, by buying shares of the fund, investors become owners of a small part of a vast variety of different bonds. More recently, investors have had an opportunity to buy shares in bond ETFs, exchange traded funds, which are similar to mutual funds and also comprise a broad selection of securities. Trading in ETFs is different from trading in mutual fund shares, and we will get back to them later.

In one of our first programs, we talked about how there are different asset classes, which are distinguished by their return rates and risk levels. It is very important for us, investors, to understand that stocks and bonds belong to different asset classes. They behave differently on the market, both from the standpoint of their return and risk (they have, as is often said, “different risk profiles”), and their performances are fairly weakly correlated. We have already mentioned that on average, over the long-term, the return on stocks is about 12 percent. Using the same disclaimers, the return on bonds is about six percent, i.e. half. On the other hand, the volatility of rates of return on bonds (and you probably remember that this is how we measure the risk of securities) is much smaller than that on stocks: bonds are not as risky as stocks.

Who among the individual investors buys bonds? For the most part, investors who prefer less risky financial instruments. Bonds are also a good fit for people who would like to invest money over a shorter term. The fact that bonds are not 100-percent correlated to stocks also makes them attractive: many investors are ready to sacrifice a small part of their return in exchange for less risky portfolios.

Our time is up. Next time, we will talk about specific types of bonds and the risk to which they are exposed. I would like to remind our listeners that on the Portfolios page of our site www.zaksinvest.com, we provide information about three model portfolios, and compare their performance to that of the market. Compare the return of your investments to our model portfolios. If you do not know what the return of your portfolio is, contact us and we will calculate it for you. This was Sergey Zaks. Thank you for your attention and until next time.