Determining who you trust to hold your money Let’s consider again the analogy to bank CDs. Both bonds and CDs tend to pay higher rates of interest the longer the time period you’re willing to lend your money. But that’s where the similarity ends. When you give your money to a savings bank to plunk into a CD, that money — your principal — is guaranteed (up to $100,000 per account) by the Federal Deposit Insurance Corporation (FDIC). For that reason, all savings bank CDs — all those that carry FDIC insurance — are pretty much the same. You can choose your bank because it is close to your house or because it gives lollipops to your kids, but if solid economics be your guide, you should open your CD where you’re going to get the highest rate of interest. End of story. Things aren’t so simple in the world of bonds. A higher rate of interest isn’t always the best deal. When you fork your money over to buy a bond, your principal is guaranteed only by the issuer of the bond, so that guarantee is only as solid as the issuer itself. (Remember my seventh-grade experience?) That’s why U.S. Treasury bonds (guaranteed by the United States government) pay one interest rate, General Electric bonds pay another rate, and General Motors bonds pay yet another rate. Can you guess where you’ll get the highest rate of interest? You would expect the highest rate of interest to be paid by General Motors (currently a somewhat shaky company). Why? Because lending your money to GM involves some risk. If GM were to go bankrupt, you might lose a good chunk of your principal. That risk requires GM to pay a higher rate of interest. Without paying some kind of risk premium, the manufacturer of gasguzzling cars simply would not be able to attract any people to lend it money to make more gas-guzzling cars. Conversely, the United States government, which has the power to levy taxes and print money (despite the cries of a few anarchistic nutcases) is not going bankrupt any time soon. Therefore, U.S. Treasury bonds, which are said to carry no risk of default, tend to pay relatively modest interest rates. If Tommy Potts were to come to me for a loan today, needless to say, I wouldn’t loan him money. Or if I did, I would require a huge risk premium, along with some kind of collateral (more than his pet turtles). Bonds issued by the likes of Tommy Potts or General Motors — bonds that carry a relatively high risk of default — are commonly called high-yield or junk bonds. Bonds issued by solid companies and governments that carry very little risk of default are commonly referred to as investment-grade bonds. There are many, many shades of gray in determining the quality and nature of a bond. It’s not unlike wine tasting in that regard. In Chapter 4, and again in Chapter 14, I give many specific tips for “tasting” bonds and choosing the finest vintages for your portfolio.
Recognizing the difference betweenbonds, stocks, and Beanie Babies Aside from the maturity and the quality of a bond, other factors could weigh heavily in how well a bond purchase treats you. In the following chapters, I introduce you to such bond characteristics as callability, duration, and correlation, and I explain how the winds of the economy, and even the whims of the bond-buying public, can affect the returns of your bond portfolio. For the moment, I simply wish to point out that, by and large, bonds’ most salient characteristic — and the one thing that most, but not all bonds share — is a certain stability and predictability, well above and beyond that of most other investments. Because you are, in most cases, receiving a steady stream of income, and because you expect to get your principal back in one piece, bonds tend to be more conservative investments than, say, stocks, commodities, or collectibles. Is conservative a good thing? Not necessarily. It’s true that many people (men, mostly) invest their money too aggressively, just as many people (women, mostly) invest their money too conservatively. The appropriate portfolio formula depends on what your individual investment goals are. I help you to figure that out in Chapters 12 and 13. By the way, these are not my personal gender stereotypes. Some solid research shows that males of the human species do tend to invest (and drive) much more aggressively than do women.
Why Hold Bonds? (Hint: You’ll Likely Make Money!) In the real world, plenty of people own plenty of bonds — but often the wrong bonds in the wrong amounts and for the wrong reasons. Some people have too many bonds, making their portfolios too conservative; some have too few bonds, making their portfolios too volatile; some have taxable bonds where they should have tax-free bonds; others have tax-free where they should have taxable bonds. Others are so far out on the limb with shaky bonds that they may as well be lending money to Tommy Potts. The first step in building a bond portfolio is having clear investment objectives. (Although I hear it from clients all the time, “I want to make money” is not a clear investment objective!) I help you to develop clear objectives in Chapter 2. In the meantime, I want you to consider some of the typical reasons people buy and hold bonds . . . both good and bad.
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