Dependable foundation of sky-high skyscrapers

Investing in bonds brings reliable and stable income to any portfolio, even if they are among the least fun gizmos in the investing world.

Bonds are probably the least-fun gizmos in the investing world. They don't tend to move wildly in price as markets fluctuate. They don't tend to get a lot of coverage on the international finance pages unless something goes very wrong. And they don't promise high returns. Yet bonds also comprise a crucial asset class for investors and savers - even those who justifiably think them a bit boring. They bring a reliable and steady income. They can help investors dial down risk. And because they pay out interest regularly, they can help older and more conservative investors counteract the evil of inflation.

"They are very important," Aadil Kadri says, a financial planner in Dubai. "They are the foundation of your skyscraper, and your foundation has to be strong to build a skyscraper." Like a stock, a bond is a security that you can buy directly from an issuer or, more commonly, on the secondary market (the bond market, in this case). Unlike a stock, which is an equity security, a bond is a debt security. Stock ownership gives you equity - or part ownership - in a company, while buying a bond gives you a share of debt. When you buy a bond, the issuer of the bond owes you money. When you buy a stock, you are investing in the issuer's business.

Bonds cropped up centuries ago, mainly as a way for governments to finance wars and raise money for large public projects. Yet while a global market for bonds has existed since well before the 19h century, it wasn't until financial mavens like Nathaniel Rothschild perfected the art of investment banking in the 1800s that bond sales took off, leading to their maturation as an investible asset class. Eventually, governments weren't the only players in the bond game; companies large and small jumped into the mix. Today, the global bond market is said to be worth about US$50 trillion (Dh183tr).

The structure of a typical bond is straightforward. It comes with a face value at which it is first sold (also known as its "par value"), a maturity date (the date by which the loan is paid off) and an interest rate, or "coupon". The term "coupon" comes from old-time bonds that actually came with a sheet of coupons that investors could rip off and redeem for interest payments over the life of the bond. A 20-year bond, for example, might be sold for US$100 and come with 20 coupons entitling the bearer to interest payments of 5 per cent a year over 20 years.

Once a secondary market developed for bonds and people started trading them regularly, "yield" came into play. Prices fluctuate when people start to trade, and if an investor buys a bond for US$110 that was sold for US$100, the value of his 5 per cent coupons goes down relative to how much he paid. He gets 5 per cent of US$100, not 5 per cent of the US$110 he actually paid. His yield is now 4.55 per cent.

Yield is thus a key metric for making bond-buying decisions. When bond prices go up - when the bonds of a government or a company are in higher demand - yields go down. And when bond prices go down - when investors get scared about a company going bankrupt and defaulting on interest payments, for example - yields trend upwards. These days, average investors need not concern themselves too much with the terminology, because there are plenty of ways to invest in bonds that don't entail a lot of analytical work. There are a bevy of mutual funds through which investors can get a diversified exposure to bonds, including the Vanguard Total Bond Market Index, which charges just 0.19 per cent in annual expenses for the privilege.

Bonds are important for investors of all ages, but they are especially crucial in retirement portfolios as investors approach the end of their working lives, when securing a regular income becomes a primary concern. Typically, financial planners advise that people who are close to retirement have roughly 80 per cent of their money in bonds, thus shielding them from the volatility of stock markets as they prepare to stop working and spend down their nest eggs.

In the long run, having money in safe bonds is better than converting it all to cash because of the threat of inflation. If prices go up, the reliable income from a solid bond portfolio can help retirees retain spending power. Even so, many advisers say retirees should keep a healthy slice of their investing pie in stocks as a further hedge against inflation. "Bonds are important in everyone's life, depending upon age and risk appetite," Mr Kadri said.

"When someone is retiring, it's a mistake to put all the money into bonds. They do not have to do that. They can keep 20 per cent in riskier funds, which can really give them support against inflation." [e-mail]