Bonds serve as the ballast in a portfolio. While stocks can earn terrific returns but also suffer significant losses, bonds have historically provided more stable, albeit lower returns.

Unlike stocks that represent ownership in a business, bonds are loans to entities like governments, municipalities, corporations, or federal agencies. Like any loan, bonds pay interest and then return the principal to the investor.

Although the concept is straightforward enough, many investors are uncomfortable investing in bonds because of the jargon, math, and the fact that bonds generally don’t trade on exchanges like stocks.

Acropolis has substantial experience in the bond market. More than half of the money that we manage is invested in bonds, three of our founders were previously bond traders, and we have two dedicated bond traders continually reviewing market conditions and identifying securities that they believe will offer the best risk-adjusted returns.

Sources of Risk & Return

Many investors only consider the yield when selecting a bond. Like most things in life, there is no free lunch in the bond market and higher yields reflect additional risks. We generally break down the risks into four broad categories: credit risk, duration (term), structure, and liquidity.

Credit risk refers to the quality of the borrower and the likelihood that an investor will actually receive the expected interest and principal payments. Consider the difference between U.S. government bonds and corporate bonds issued by now-bankrupt Lehman Brothers. The government can print money to repay bonds where Lehman defaulted, stopped paying interest, and creditors are now fighting to divvy up what remains to former bond holders.

Duration, or term, represents the time that you are willing to loan your funds. It makes sense to demand more interest on a bond that will pay back in 30 years than a bond that pays back in three months. Duration is a major factor in the volatility of a bond – the longer the duration, the more volatile the bond.

Structure refers to the timing of interest payments and principal repayment. A bond can earn no interest and accrue in price, pay a fixed interest rate, a floating interest rate, or even pay interest and principal back each month. Structure is very difficult for individual investors to analyze and can be a source of risk and return.

Liquidity refers to the ability to sell a bond (or any security) without affecting its price. Imagine that you wanted to sell your house in 24 hours – you would expect to receive a substantial discount in exchange for selling a unique asset on short notice. If you were selling a diamond, you could expect to get market price for a diamond even on short notice because diamonds are pure commodities. Some bonds like U.S. government t-bills are commodities, while other bonds from a small issuer that trade infrequently will be illiquid. In exchange for the illiquidity, investors require a higher yield.

All of these characteristics and others play a role in our security selection. As we consider various opportunities, we constantly look at the potential risks along with the possible returns for our clients. Our goal is to find the best relative value and risk-adjusted return.

Acropolis Investment Management is a St. Louis based fee-only private wealth management firm, staffed with dedicated financial planning professionals ready to work with you to reach your investment goals.  Whether you are looking to start your retirement planning, need help with your portfolio asset allocation, or rolling over your IRA or 401K we are here to help. To learn more about our financial planning services, please contact us at 1-888-882-0072.