Stocks, bonds, and notes are three staple assets for investors seeking growth or stability. Bonds and notes are the more stable assets. But what is a bond? How are bonds, bills, and notes different?
To begin with we need to understand asset classes: they're groups of similar investments, such as cash and cash-equivalents, bonds, equities, real estate, tangibles, and other alternative investments. A good portfolio will balance the different classes to achieve goals such as liquidity or growth or diversification.
Different asset classes have perks and downsides. For instance, cash and equivalents are considered the standard for liquidity. Cash equivalents include short-term treasury bills, and short term certificates of deposit.
Equities (aka stocks) are considered a staple for growth investing. Real estate and tangible goods such as gold or grain or goats tend to be secure through inflation. Alternative investments are something of a catch-all for things such as cryptocurrencies, which are beyond the present scope.
Which leaves bonds and fixed-income assets. In short, they are loans that are fairly stable. I consider them somewhere between stocks and cash in terms of volatility and return. If the loan is to a company, then it is called a corporate bond. If it is to the US Treasury, it's called a treasury. If it's to a state or local government, it's a municipal bond.
To further confound matters, treasuries get special names depending on how long they take to reach maturity. Treasury bills take one year or less, treasury notes take between a year to a decade, and more than a decade is confusingly called a treasury bond.
Bonds and Risk
Investors might choose bonds for the low-risk and steady cashflow, typically in retirement when those are needed. However, bonds are not risk-free.
Bonds are purchased either directly when first offered, or on a secondary market – a bond market. If you hold onto a bond, its return is set. However, trading before its maturity results in unavoidable risks.
To begin with, bond prices are inversely related to interest rates. When interest rates fall, bond prices tend to rise, and vice-versa.
Another major consideration is that because of their fixed-income nature, bonds are particularly susceptible to inflation eating away their returns. This is more important for long-term bonds looking years down the road, but this affects investors who hold onto bonds.
Finally there is that looming threat of the bond going into default. This is more relevant to corporate bonds, where companies may declare bankruptcy. It's worth nothing that treasuries are backed by the US government, which makes them significantly less likely to default.
Long Story Short
Ultimately, bonds are another financial instrument with a unique blend of attributes. These attributes make them handy as low-risk sources of cash flow.
Conventional financial wisdom states that as you age, you should convert more and more risky assets into bonds and similar. The reasoning is simple: when you're older, you have less lifespan available to sit around and wait for volatile investments to recover. Their cash flow is also a boon, since you should be retired and not generating active income.
I hope this article helps you understand bonds as an asset, and that it clears up questions you didn't know that you had!