All About Bonds, Bond Mutual Funds, and Bond ETFs

All About Bonds, Bond Mutual Funds, and Bond ETFs

CHAPTER 1
What Bonds Can Do
for You and Why You
Should Consider
Investing in Them
1
KEY CONCEPTS
■ Reasons for investing in bonds
■ What are bonds?
■ Terminology of bonds
■ How to buy and sell bonds
History provides not only insights into past returns from investing in
the stock and bond markets, but also valuable lessons for investing in
the future. Evaluating the performance of stocks and bonds can provide

you with insights into planning your investments for the future.
Advocates of stock investments quote historic returns over long periods

of time, such as 20-, 50-, and 100-year periods because stocks
have consistently outperformed bonds and other financial asset
classes. However, when the time frame falls to shorter time periods
(less than five years) the results can be markedly different, as Table
1-1 illustrates. The performance of bonds over two- to five-year periods

has often outperformed the returns of stocks and money market
securities (cash equivalents). Within these shorter time frames, there
are at least two sets of circumstances where bonds outperform stocks.
During recessions, bonds generally provide better returns than
stocks, and when both interest rates and inflation are rising, shortterm

bonds (Treasury bills and money market equivalents) often
outperform both long-term bonds and stocks.

An example illustrates the risk of loss from investing in only
one asset class. If you had invested solely in stocks in the time period
from March 1995 through March 2000 you would have earned

spectacular returns, as the U.S. stock markets reached their all-time highs
in March 2000. During that time period, other financial securities
such as bonds and money market securities could not match the
stellar stock market returns. However, for the following two and a
half years, the broad stock market index fell by 50 percent, and technology

stocks declined by roughly 80 percent, while bonds earned
positive returns. For the next two and a half years through March
2005, the stock markets increased but they came no where near the
highs of March 2000.
If you were clairvoyant you would have invested solely in
stocks from 1995 to 1999, switched to bonds January 1, 2000, through
2002, and then switched back to stocks in 2003 through 2004, and
your returns would have been hard to beat. The problem is that we
do not know when we should be fully invested in stocks and when
we should switch to bonds. The lessons that we can learn from this
example are:
■ It is virtually impossible to determine how the markets
will perform in the future and so we should not have all
our eggs in one basket, so to speak, by investing solely in
stocks or bonds. We want to minimize the risk of loss.
■ The key to minimizing the risk of loss is to invest in
different classes of investments whose returns are not
correlated—in other words, investing in asset classes

All About Bonds, Bond Mutual Funds, and Bond ETFs