Top 6 Uses For Bonds
Individuals and institutions can use bonds in many ways: from the most basic, such as for preserving principal or saving and maximizing income, to more advanced uses, like managing interest-rate risk and diversifying a portfolio.
Bonds can also be an afterthought, especially during flight-to-quality events, when investors flock to the safest bonds they can find to weather financial storms. In fact, bonds are much more complex and versatile, and can provide investors with a variety of options. (To learn more, read our Bond Basics Tutorial.)
One of the most common uses of bonds is to preserve principal. While this concept works best with bonds that are perceived to be risk-free, like short-term U.S. government Treasury bills, investors can apply it to other types of bonds as well.
Barring any catastrophic events, bonds are effective in preserving principal. Because bonds are essentially loans with scheduled repayments and maturities, lenders (bondholders) can expect their bonds to retain value and terminate at par upon maturity. (For further reading, see Common Mistakes By Fixed-Income Investors.)
Saving for the future has historically been one of the best uses of bonds. Savings bonds, as they are aptly named, provide one of the most secure and time-tested approaches to long-term saving. They are guaranteed by the full faith of the U.S. government and are sold in various formats, including discount and interest-paying formats.
Savings bonds are designed to be held to maturity and are typically given as gifts to young investors to help them learn about saving. (To learn more, read The Lowdown On Savings Bonds.)
Managing Interest-Rate Risk
Interest-rate risk is the inherent risk that the price of a bond will fluctuate with prevailing rates. This risk exists because a bond's priced value is a culmination of the present value of the future interest payments and returned principal upon maturity.
Because of this valuation, there is an inverse relationship between the bond's current price and the prevailing rates. For example, when current rates rise, all else being equal, the price of the bond should fall. (Get a deeper understanding of the importance of interest rates and what makes them change in Forces Behind Interest Rates.)
The generally low correlation between bonds and other asset classes makes bonds an excellent diversification tool. For example, one could create a simple portfolio of large-cap stocks and U.S. government bonds where the cross correlation between the assets is usually less than one.
While it is rare to finds two assets that are perfectly negatively correlated, the diversification between bonds and stocks cans help to smooth out those volatile market swings, especially during flights to quality. (They may not be sexy, but bonds do have a place in every balanced portfolio. Find out why in Advantages Of Bonds.)
Individuals commonly use bonds to match a future expected cash need. Institutions also use this strategy on a more complex basis called immunization. The concept assumes a match of the duration of the bond to the expected cash flow, which can be easily accomplished by using a zero-coupon bond in which the maturity matches the bond's duration. However, this will not provide any income over the life of the bond. Read Immunization Inoculates Against Interest Rate Risk to learn more about this concept.
One of the benefits of bonds over other asset classes is that bonds have a predictable stream of income that can be used to fund future expenses for individuals and corporate pension obligations for institutions. This is one of the reasons financial institutions, like banks and insurance companies, use long-term bonds for their long-term planning.
Bonds enable them to match their assets to liabilities (commonly known as asset/liability matching) with a much higher degree of certainty than with other asset classes.