Market Decode: How bonds work — and what they can do for you

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Generally considered the more boring, conservative part of an investor's portfolio, bonds typically don't get as much press as stocks do. And because they function differently from stocks and come in so many different flavors — Treasuries, municipals, corporate, high yield, etc. — they can be confusing. Here, Matthew Diczok, fixed income strategist for the Chief Investment Office at Merrill and Bank of America Private Bank, offers a clear, simple explanation of how bonds work and why they could be considered an important part of an investor's strategy.
How bonds work and what they can do for you
Onscreen copy: Please see important information at the end of this program. Recorded 2/28/18.
[ON-SCREEN TEXT]
Matthew Diczok
Fixed Income Strategist, Chief Investment Office
Merrill and Bank of America Private Bank
Matt Diczok: Stocks and bonds — they're two words that are often paired together, but they're very different. Stocks are in the news pretty much daily, especially when markets are volatile.
Bonds, on the other hand, are usually talked about less — and are a little more complicated… But they could play a really important role for investors, especially when markets are unsettled. To compare the two, if owning a stock is like owning a little piece of a company, owning a bond is like owning a little piece of a loan.
Many types of borrowers — companies, governments, government agencies — issue bonds to fund a wide range of activities…
Everything from building roads and bridges, to investing in new plants and equipment, to buying other companies.
And the investors, called bondholders, get regular interest payments in return for lending money to these borrowers.
That's the primary benefit of bonds: They offer a set interest rate — also known as the "coupon rate" — at regular intervals until the end of a bond's term, or its "maturity date."
As long as the bond issuer doesn't default, something known as "credit risk" — you'll receive your investment — the "principal" amount — at that maturity date.
So let's say you buy a 10-year, $1,000 dollar bond paying five percent interest:
You'll receive fifty dollars every year for 10 years, and when the bond matures, you'll get that $1000 back.
There are many different kinds of bonds issued, and which types you choose for your portfolio will depend on your goals, time horizon and how much risk you're comfortable with.
For example, U.S. Treasury bonds are backed by "the full faith and credit of the U.S. government," and therefore are considered the safest type of bonds, with no credit risk. For that reason, though, the interest rate they pay is relatively low.
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(Alt Text: A picture of a lever comes on screen with two columns on either end to illustrate the types of bonds. On the left it has "more risk" at the top and "less risk" on the bottom. One the right it has "Lower return" at the top and "higher return" at the bottom. "U.S. Treasury Bonds" comes on screen and points to the "less risk" and "lower return" portions of the columns.)
State and local governments also issue bonds — known as "Municipals" — as do "investment grade" companies — who issue corporate bonds.
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(Alt Text: A picture of a lever comes on screen with two columns on either end to illustrate the types of bonds. On the left it has "more risk" at the top and "less risk" on the bottom. One the right it has "Lower return" at the top and "higher return" at the bottom. "Municipals and investment grade corporate bonds" comes on screen and points to the middle of each column to illustrate moderate risk and moderate returns.)
Both types of issuers generally have strong credit ratings, and offer slightly higher yields than Treasurys for slightly higher credit risk.
"High-yield" corporate bonds and some international bonds — on the other hand — carry higher coupon rates but come with significantly more risk.
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(Alt Text: A picture of a lever comes on screen with two columns on either end to illustrate the types of bonds. On the left it has "more risk" at the top and "less risk" on the bottom. One the right it has "Lower return" at the top and "higher return" at the bottom. "High-yield corporate & international bonds" comes on screen and points to the "more risk" and "higher return" parts of the columns.)
So there's always a trade-off between the coupon a bond pays and the amount of credit risk it presents to its bondholders
Another important factor: In general, the longer the time until a bond matures, the higher coupon rate you'll receive. So a 30-year Treasury bond will generally pay a higher rate of interest than one with a maturity of 5 or 10 years for example.
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(Alt Text: A bar with 2 year at the bottom goes up to 30 years at the top while a percentage bubble illustrates how the percentage rate goes up for the longer the bond maturity.
When it comes to your investments, Bonds matter for several reasons.
First, they can provide you with a relatively predictable income stream.
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  1. Predictable Income Stream

    Second, bond prices don't vary as much as stock prices do. So bonds can potentially provide a source of stability in a portfolio.
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  1. Potential Source of Stability

    Finally, bond prices may move differently than stock prices — rising in price as stock prices fall.
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  1. Prices may move differently than stocks

    This means they should be considered an essential part of a well-diversified portfolio.

    Whatever approach you take, knowing your tolerance for risk, your financial goals, and your timeframe for meeting those goals are essential in assessing how many and what type of bonds are best for you.
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Know your:
  • risk tolerance
  • financial goals
  • timeframe
Disclosure:
IMPORTANT INFORMATION
Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.
Investing involves risk including possible loss of principal. Asset allocation, rebalancing and diversification do not ensure a profit or protect against loss in declining markets. Past performance is no guarantee of future results.
Investments in high-yield bonds (sometimes referred to as "junk bonds") offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer's ability to make principal and interest payments.
Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal alternative minimum tax (AMT).
Investments focused in a certain industry may pose additional risks due to lack of diversification, industry volatility, economic turmoil, susceptibility to economic, political or regulatory risks, and other sector concentration risks.
The views and opinions expressed are those of the speakers, were current as of February 28, 2018 and are subject to change without notice at any time, and may differ from views expressed by Merrill or other divisions of Bank of America Corporation. These discussions are provided for informational purposes only and should not be used or construed as a recommendation of any service, security or sector.
The investments or strategies presented do not take into account the investment objectives or financial needs of particular investors. It is important that you consider this information in the context of your personal risk tolerance and investment goals. Due to the time-sensitive nature of the content and because investment opinions may have changed since the time any comments were made by research analysts, the latest Merrill investment opinion and investment risk rating for any particular security discussed should be reviewed, including important disclosures, before making an investment decision.
The information presented here is not intended to be either a specific offer to sell or provide, or a specific recommendation to buy any particular product or service.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. All sector and asset allocation recommendations must be considered by each individual investor to determine if the sector is suitable for their own portfolio based upon their own goals, time horizon, and risk tolerances.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.
Neither Merrill nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Merrill Private Wealth Management is a division of MLPF&S that offers a broad array of personalized wealth management products and services. Both brokerage and investment advisory services (including financial planning) are offered by the Private Wealth Advisors through MLPF&S. The nature and degree of advice and assistance provided, the fees charged, and client rights and Merrill's obligations will differ among these services. Investments involve risk, including the possible loss of principal investment.
Merrill Lynch, Pierce, Fenner & Smith Incorporated (also referred to as "MLPF&S" or "Merrill") makes available certain investment products sponsored, managed, distributed or provided by companies that are affiliates of Bank of America Corporation ("BofA Corp."). MLPF&S is a registered broker-dealer, member SIPC and wholly owned subsidiary of BofA Corp.
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A well-diversified portfolio should include a mix of stocks, bonds and cash (the three major asset classes). How much of each you hold depends on your financial goals, risk tolerance, time horizon and liquidity, or cash, needs.
When it comes to bonds (also referred to as fixed income), there's a general rule of thumb: The more conservative you are as an investor, the more bonds you may want to own, relative to stocks (also known as equities). If you're willing to accept a greater amount of risk — and have a longer time horizon to pursue your investment goals — you may be more comfortable with stocks than with bonds.
Watch our video and then check out our slideshow below to find a recommended asset allocation based on the type of investor you are.
This chart presents a sample asset allocation for a conservative investor with investments of 16% cash, 26% stocks and 58% bonds. Source: Chief Investment Office, January 2020. Disclaimer: The strategic allocations shown here are designed as guidelines for a 25-year investment horizon for investors with the highest level of liquidity needs.
Note: These allocations may be subject to change based on periodic review and are for illustrative purposes only. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.
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Diversification does not ensure a profit or protect against loss in declining markets.

Investing involves risk including the possible loss of principal investment.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Investments in high-yield bonds (sometimes referred to as "junk bonds") offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer's ability to make principal and interest payments.

Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is generally tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT).

Investments focused in a certain industry may pose additional risks due to lack of diversification, industry volatility, economic turmoil, susceptibility to economic, political or regulatory risks, and other sector concentration risks.

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