Stocks and bonds. You don’t have to be an investor for very long before somebody probably suggests that you should have some of both. Bonds are supposed to be your financial safety net, while stocks are where you hope to earn your higher-flying returns … or so you’re told.

Okay, but why … and how? What is a bond versus a stock, anyway? Are there times and market conditions when these rules of thumb no longer apply? What should I do if that happens? And, by the way, if bonds are supposed to be so “safe,” why do my bonds or bond funds sometimes decline in value?

Let’s begin at the beginning: What IS a bond versus a stock?

When you buy a bond …

  • You are lending money to a business or government agency, with no ownership stake.
  • Your returns come from interest paid on your loan – otherwise known as fixed income.
  • If a bond goes belly up – i.e., the borrower defaults on what they owe you – you are closer to the front of the line of creditors to be repaid with any remaining capital than if you owned a stock.

Now here’s what happens when you buy a stock …

  • You become a co-owner, with equity in the business. You even get voting rights at shareholder meetings.
  • Your returns essentially come from increased share prices and, sometimes, dividends. You hope to sell your company stake for more than you paid for it.
  • If a company goes bankrupt, you are closer to the end of the line of creditors to be repaid.

So, to recap: A bond is a loan rather than an ownership stake. Returns primarily come from interest paid on the loan. And you have a better chance of receiving at least some of your stake back if the bond defaults on what it owes you.

I’ll talk about defaults in a moment. For now, the point is that these differences help explain why, over the long-term, bonds have generally offered lower, but more stable returns, while stocks have offered up higher returns but a bumpier ride, as illustrated in the classic “Stock, Bond, Bills and Inflation” chart you’ll find displayed in many an advisor’s office.

So, what does all this mean to your bond investing? Whether you’re invested directly in bonds or indirectly via bond funds, should you try to time higher- and lower-interest rate environments by jumping in and out of the bond market?

Whether we’re talking about stock markets, bond markets or any other financial market, my answer is an emphatic “no” with respect to market timing. A body of academic evidence has long been clear about the imprudent risks involved in trying to time the markets – any markets. The evidence informs us:

  1. We cannot consistently predict what is going to happen next on market pricing, in any market.
  2. Whether your timing turns out to be good or bad (both out, AND back in), the trades involved cost real dollars – which can be particularly burdensome in the bond market.
  3. Reacting to near-term market conditions also knocks you off-course from your well-laid plans, into an ever-escalating cycle of stressful, random decision-making. Why go there, when sticking with evidence-based, long-term plans offers the best odds for ultimate success?

Bottom line, IF an allocation to bonds makes sense in your well-planned portfolio, it should make sense regardless of current market conditions.

But before you go feeling as if you’re helpless in the face of whatever nastiness the future has in store, there are some good, proactive steps you can take to shore up the solidity of your bond or bond fund holdings. Even better news: If you take most of these steps upfront, you should then be positioned as well as you can be to withstand whatever the bond markets throw your way, so you can get on with the rest of your life.

Are you ready? Here is your line of defense:

First, form a plan, and invest accordingly.

Next, as you invest, use low-cost investments that limit your exposure to the two types of risk you’ll find in bond investing. The first kind of risk is credit risk — or the risk that your bond will default on its obligations. The other kind is term risk — or the increased uncertainty inherent to bonds with distant due dates. To defend against both risks, we typically build our bond portfolios using bonds with credit ratings of AA or higher, and with terms in the range of 2 to 5 years, or shorter.
Periodically assess your progress.

Unless your own goals have changed, stay put along the way.
Now I know what you’re probably thinking: Those two risks I just mentioned are still a little hazy.

The concept of credit risk is relatively straightforward. Just as there are shady people to whom you’d never give a loan, there are plenty of low-grade companies who may tempt you with higher interest payments … but if they instead go belly up, so too do those promised payments. You can spot bonds with higher credit risk by their ratings, The higher in the alphabet you go — such as “B” or beyond — the worse the rating, which is why we generally stick with those rated AA or higher. There’s a time and place for taking on market risks, but It’s just not worth investing in junk bonds for the “safe” side of your portfolio.

Last but not least, there’s term risk to talk about, which also addresses why your bonds or bond funds sometimes decline in value. Since that one gets a little more detailed, I’m dedicating my next “No Dumb Question” segment to that very subject! For now, if you could use some help with your bond investing, my team and I are available to assist.