Many individuals generally view bonds as conservative investments that provide steady income and a higher degree of protection of principal. When the equity markets do exceptionally well, it may be tempting to overweight your portfolio with equity investments. However, it’s important to maintain an even approach to investing during market swings and to ensure your investments are well diversified at all times. Thus, bonds may merit consideration as a component of your portfolio.

Equity vs. Fixed Income

When it comes to investing, you can be either an owner or a lender. If you own stock (or shares of a mutual fund that invests in stocks), you are a shareholder and literally own a part of a company. The company has no obligation to pay you back by redeeming your shares, and the value of your shares will rise or fall with the fluctuations of the market.

On the other hand, when you buy bonds, you are acting as a lender. That is, you are “lending” your money to an entity (e.g., a company, state, municipality, or the U.S. government) for its promise to pay, which takes the form of periodic interest and a return on your principal. The borrower does have an obligation to you (the bondholder), to repay. However, it is possible for the borrower to default on this obligation to pay interest and principal.

Bond Basics

One of the most common questions posed by potential bond investors is: “What is bond yield?” When most people mention yield, they are referring to current yield (i.e., the current annual interest income divided by the initial price paid for the investment). Perhaps a better measure for investors is yield to maturity, which provides the most complete measurement of performance, taking into account the present value of future interest payments.

There are several factors that can affect yield. However, one of the more important considerations is credit rating. Lower quality issues tend to pay higher yields to compensate for added risk. In addition, for bonds carrying similar credit ratings, it is typical that the longer the time until maturity, the higher the yield tends to be.

What About Bond Funds?

Like stocks, successfully investing in bonds requires a great deal of knowledge and experience. For this reason, bond mutual funds can be a good way to incorporate bonds into your portfolio. A bond fund is managed by financial professionals who use their knowledge and experience to purchase a variety of bonds that are consistent with the fund’s stated objectives. However, unlike individual bonds, a bond fund has no obligation to pay a stated interest rate or return your principal. As an investor, you should be aware that investment returns and principal values of bond mutual funds will fluctuate due to market conditions. Therefore, when shares are redeemed, they may be worth more or less than their original cost.

Many investors who understand bond yield may still have a difficult time accurately comparing the performance of bond funds when fund companies calculate and advertise yields in different ways. Fortunately, the Securities and Exchange Commission (SEC) has established an industry standard for computing yield in mutual fund advertisements and sales literature. The standard creates a fixed-yield quote requirement for bond mutual funds, making it easier for investors to decide which bond funds are most suitable for their individual investment portfolios. In addition, a fund’s prospectus can be consulted for a complete list and description of its holdings, as well as information on risks, fees, and expenses. Always read it carefully before investing.

Before You Decide. . .

Bonds can be a valuable addition to your portfolio because of their ability to help maintain principal and provide income. However, the percentage of your portfolio you choose to invest in bonds should be determined by your overall goals and objectives. Despite the allure of potentially higher returns from equities, bonds may still deserve some of your investment attention.