ELI5 - Why Buy Bonds?

We've talked a lot about stocks, today let's take a look at the safer side of portfolios and talk about the value of bonds.

First, How Do Bonds Work?

Bonds are loans. We're all familiar with borrowing money, whether it's mortgages, credit cards or student loans.

Regardless of how you borrow, the process typically looks like this:

1) A lender gives you money.

2) You promise to pay it back (with interest) in the future.

This is how bonds work but the roles are reversed. You become the lender. Bond issuers are the borrower and they are obligated to pay YOU back. Oh how the tables have turned.

Bond issuers are typically governments and corporations. Governments issue bonds to fund initiatives such as roads and schools. Corporations issue bonds to fund their business.

So Why Buy Bonds?

Bonds typically generate a much lower return than stocks. Returns are even lower these days given the rock-bottom interest rates. Given the poor returns, why buy them?

It all comes down to risk management. Bonds are less volatile, providing a much more stable return. This means smaller upside potential but also less downside potential. Lower rewards but lower risk. This comes especially handy during times of turmoil.

Investors with a long time horizon (or higher risk tolerance) will typically have more stocks in their portfolio, they can handle the turbulence. Those who are retiring soon (or can't stomach the rollercoaster ride) will have more bonds. It would be risky for near-retirees to own mainly stocks. A common theme in portfolios is a gradual shift from stocks to bonds as one grows older.

Bonds are a valuable investment, but their value comes not from creating wealth but from protecting it.

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