Bond Basics: Income to Stabilize for Your Portfolio.

You may be tempted to put all your money into stocks when the stock markets are doing exceptionally well. However, investors must keep their long-term goals in mind, balancing (and rebalancing) their investments during market swings to keep assets well-diversified. Here's where bonds come into play in your portfolio, providing a more conservative option that can provide steady income and a higher degree of principal protection.

Equity vs. Fixed Income

As an investor, you can be an owner or a lender. For example, if you own stock, you are a shareholder and own a part of a company (equity). However, the company has no obligation to pay you back by redeeming the shares you own, and the value of your shares may rise and/or fall with market fluctuations.

Alternatively, you act as a lender when you purchase bonds. You are "lending" your money to an entity, e.g., a company, state, municipality, or the U.S. government, in exchange for their promise to pay you interest (fixed income) and a return on your principal. Unlike stocks, the borrower has an obligation to you as a bondholder. But the borrower can also default on their obligation to pay interest and principal—therein lies a fraction of the risk when purchasing bonds.

Bond Basics

Potential bond investors often ask, "What is a bond yield?" When you hear the word yield mentioned, it's often about a bond's current yield, i.e., the current annual income divided by the initial price paid for the investment. However, there is another, more complete measure for a bond: yield to maturity, which captures the present value of the bond's future interest payments. 

Many factors affect yield; an important one is a bond's credit rating. Lower-quality bonds tend to pay higher yields to compensate for the added risk. Additionally, for bonds carrying similar credit ratings, it is common that the longer a bond has until maturity, the higher the yield tends to be.

What About Bond Funds?

Like for stocks, successfully investing in bonds requires a great deal of knowledge and experience, which is why bond funds are an excellent way to incorporate bonds into your investment strategy. A bond fund is managed by financial professionals who use their knowledge and experience to purchase various bonds (diversification) consistent with the fund's stated objectives. But unlike the individual bonds already mentioned, a bond fund has no obligation to pay a stated interest or return your principal. As an investor, you should know that bond mutual funds' investment returns and principal values will fluctuate due to market conditions. Therefore, when shares are redeemed, they may be worth more or less than their original cost.

Before You Decide…

Again, bonds can be a valuable addition to your portfolio because they can balance growth and income in your account, helping you maintain the principal and providing interest income. However, what percentage of your portfolio you choose to invest in bonds, like all investments, should be determined by your investment strategy, stated goals, and objectives.

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