While most people are familiar with stocks, since the nightly news talks about the daily happenings in the stock market, i.e., the Dow Jones Industrial Average was up or down that day, few people I talk to know anything about bonds. Bonds are interesting creatures and where I spent the bulk of my time as an investment professional. They are an important investment tool for shorter term investment goals and diversifying your investment portfolio.

Bonds are government or corporate debt. In contrast to stocks, bonds do not offer any growth potential. Where stocks offer the opportunity for unlimited increases (or decreases) in value based on a company’s ability (or lack thereof) to increase its profits, bonds offer something entirely different. They offer a promise; regular interest payments and the return of the money that was borrowed, known as principal. Bonds in general (with some exceptions) are less risky than stocks because of this promise, which is in fact a contract. However, because all you get is what you are contractually entitled, they also offer less return; essentially the promised interest rate on the bond if you hold the bond for the contract term.

The value/price of bonds fluctuates during the time they are paying interest, before the final payment of principal. The drivers of price changes are changes in interest rates, known as interest rate risk, and changes in the perceived ability of the borrower to make the interest and principal payments on the bond, known as credit risk. For more in-depth discussions of interest rates and credit risk see my related posts.

If interest rates go down, the price of a bond will go up. That is because the interest payment from the outstanding bond is higher than what is available on a newly issued bond. The value of a newly issued bond is generally the amount of money the investor is lending, called the par value. An investor who buys an outstanding bond is buying the future interest and principal payments. So investors are willing to pay more for the outstanding bond, up to the point where the expected return on the outstanding bond, if held to maturity, is the same as the newly issued bond’s contractual interest rate.

The opposite is true if interest rates rise above the interest rate on the outstanding bond. The future interest and principal payments on the outstanding bond will be worth less than the newly issued bond, and the price will decline. These changes in value are known as interest rate risk. Interest rate risk increases with the length of time to maturity. All bonds get less risky as their maturity date approaches.

Most people own bonds through mutual funds. As discussed in the previous Investing 101 post, mutual funds pool many investors’ money to buy a portfolio of investments, in this case bonds. Bond mutual funds generally target a specific maturity range, such as short term (up to three years to maturity), intermediate term (four to ten years to maturity), or long term (more than ten years to maturity). So bond mutual funds never get shorter in the way that a specific bond gets shorter and less risky. The interest rate risk associated with a bond mutual fund remains relatively constant.

Short term bond funds are the least risky, and historically have provided positive returns in most time periods. Intermediate term bond funds are subject to negative returns over short time periods, but if held at least three years, historically have very rarely posted negative returns. Long term bond funds are quite risky, and the range of valuation changes historically has been similar to that of stock market averages. To minimize the possibility of losses, you would need to commit to having long term bond funds for at least ten years, like stock funds.

Bonds, or bond mutual funds are an important investment vehicle. For shorter term investment objectives, they are a better alternative than stocks, because there is a lower likelihood of loss, particularly if you line up the bond term with the time to meet your objective. For spending needs within the next three years, use short term bond funds. For spending needs three to ten years out, use intermediate term bond funds. For longer investment horizons use stock mutual funds.

Even if you don’t have short term needs for your savings, bonds  are an important tool. They are the ultimate portfolio diversifier, if you already own stocks or stock mutual funds. The valuation changes of bonds are generally unrelated to the changes in the value of stocks. Because the price changes of stocks and bonds are unrelated, the overall range of changes in value of a portfolio holding both will be narrower than holding stocks alone. Adding bonds to your investment portfolio will lower both the portfolio risk and return. While no one wants to give up returns, some buffer against the extremes of the stock market is likely to help you sleep better and stick with your investment strategy when the stock market dips.