When Andrew Mellon famously said, “Gentleman prefer bonds,” the world was very different than it is today. In 1925, Anita Loos wrote her book Gentlemen Prefer Blondes, which was made into the classic 1953 film starring Marilyn Monroe.

Mellon was nearly midway through his tenure as U.S. Treasury Secretary, which lasted from 1921 - 1932. At the time, the stock market was known for its speculative frenzy leading up to the Crash of 1929. In contrast, bonds were seen as a safer and more stable investment.

Government and high-grade corporate bonds were considered less risky and more suited for conservative investors. Mellon’s quote suggests that sophisticated investors, who might prioritize preserving wealth over seeking high-risk returns, would naturally lean towards bonds. It plays on the idea that gentlemen would favor investments that provide steady, reliable returns rather than the volatile gains of stocks.

In today’s Rude, I will introduce, or reintroduce, you to the world of bonds in a simple way.

Why Investing in Bonds is a Good Thing: A Primer for Stock Investors

As someone deeply entrenched in finance and investment, I often come across seasoned stock investors who, surprisingly, know very little about bonds. While stocks tend to dominate the headlines with their rollercoaster ride of price movements and potential for massive returns, bonds quietly serve as the bedrock of our capital markets… and many successful investment portfolios.

This week, I'll be heading to Frankfurt to teach a two-day class on bonds—a topic that's crucial for a well-rounded investment strategy and deserves more attention than it typically gets.

I'll explain the basics of bonds, why they should be a vital component of an investment portfolio (stock and options traders are exempt from this), and demystify some of the misconceptions surrounding them.

If you know your way around stocks but haven't yet dipped your toes into bonds, consider this your introductory guide.

What Are Bonds?

Let's start with the basics. A bond is two things. First, it’s a promise. “My word is my bond.” Dictum meum pactum. It’s literally a promise to repay. Now comes the second, cooler part. It’s a tradable loan. That means when someone doesn’t want your repayments anymore, they can sell your bond to someone else, and you can repay them instead.

Dear reader, this tradability is a miracle. It allows investors to offload risk without having to break anyone’s kneecaps. Just sell the bond for its current price, which may be less than you paid, and you can invest those proceeds elsewhere. Or just stick the money in a bank.

When you buy a bond, you're lending money to the issuer in exchange for periodic interest payments (coupons) and the return of the bond's face value when it matures. The word “coupon” comes from the French couper, which means “to cut.” In the old days, you cut the coupon off the bottom of your bond and brought it to the bank to exchange it for your interest payment.

Think of bonds as IOUs with a fixed income component. Unlike stocks, which represent ownership in a company, bonds are debt securities. As a bondholder, you don't get a say in how the company is run, but you have a claim on its assets and earnings before shareholders do, especially in bankruptcy.

Why Should You Invest in Bonds?

If you're a stock market fan, you might wonder: Why should I bother with bonds? Aren't stocks the better investment? While stocks have the potential for higher returns, bonds offer several unique benefits that make them an essential component of a balanced investment portfolio.

Stability and Predictability

One of the most compelling reasons to invest in bonds is their relative stability compared to stocks. Bonds are less volatile because they provide predictable income streams through regular interest payments. This stability is desirable in uncertain economic climates or market downturns when stock prices are wildly unpredictable. 

For example, during the 2008 financial crisis, while global stock markets were in freefall, many high-quality bonds held their value or even appreciated. This is because bonds, especially government bonds, are seen as safe havens in times of crisis.

However, the 60/40 portfolio, a popular investment strategy that allocates 60% to stocks and 40% to bonds, was severely tested during the 2020-2023 period, which saw a significant decline in bond values and raised questions about the traditional wisdom of this allocation.

Income Generation

Bonds are a reliable source of regular income, making them an attractive option for investors looking to generate a steady cash flow. This is especially true for retirees or those approaching retirement who need a consistent income stream without the risks associated with more volatile investments like stocks.

Bond interest can be predictable and, in some cases, tax-advantaged, depending on the type of bond and the investor's tax situation. For example, municipal bonds in the United States provide tax-free interest income at the federal and, in some cases, state and local levels.

Diversification Benefits

If you're heavily invested in stocks, adding bonds to your portfolio can provide diversification benefits that reduce your investment risk. Stocks and bonds often have an inverse relationship, meaning bonds tend to hold steady or even rise when stocks go down. This counterbalancing effect can smooth out your portfolio's volatility and protect it from extreme swings in value.

Diversification is a crucial principle of modern portfolio theory, which suggests that a mix of asset classes—such as stocks, bonds, real estate, and commodities—can maximize returns for a given level of risk. By holding both stocks and bonds, you spread your risk and improve the potential for a more stable return.

Of course, with the Fed printing money, that rising tide lifted all boats and led to an unwelcomely higher correlation between stocks and bonds.

Capital Preservation

Capital preservation becomes a priority for investors who are more risk-averse or nearing their financial goals. Bonds, particularly high-quality government and corporate bonds, are excellent for preserving capital. Unlike stocks, which can lose significant value quickly, bonds offer a fixed return and the repayment of principal upon maturity, provided the issuer does not default.

Think of bonds as the ballast of a ship—they provide stability and reduce the portfolio's sensitivity to market turbulence. This characteristic is particularly valuable for investors who cannot afford to lose a significant portion of their investments, such as retirees or those saving for a near-term goal like buying a home or funding a child's education.

Inflation Protection

While bonds are often perceived as a poor hedge against inflation, certain types can offer protection from rising prices. Treasury Inflation-Protected Securities (TIPS) in the U.S., for example, adjust their principal and interest payments based on inflation, helping to preserve the purchasing power of your investment.

Moreover, floating-rate bonds—where the interest rate resets periodically based on a benchmark rate—can also provide some protection in a rising interest rate environment, which is often a sign of inflationary pressures.

Understanding Bond Risks

No investment is without risk, and bonds are no exception. However, understanding these risks can help you make more informed investment decisions.

Interest Rate Risk: Bond values tend to move inversely with interest rates. When interest rates rise, bond prices typically fall, and vice versa. This is particularly relevant for long-term bonds, which are more sensitive to interest rate changes.

Credit Risk: This is the risk that the bond issuer will default on its obligations. Bonds issued by entities with lower credit ratings generally offer higher yields to compensate for this increased risk but also carry a higher chance of default.

Inflation Risk: Fixed-rate bonds can lose value in real terms if inflation rises significantly, eroding the purchasing power of the fixed interest payments.

Liquidity Risk: If the market for some bonds is thin, some bonds, particularly those issued by smaller companies or municipalities, may not be easily sold without potentially incurring a loss.

Despite these risks, bonds remain a foundational element of a well-rounded investment portfolio, mainly when appropriately managed within an investor's overall risk tolerance and investment objectives.

How to Invest in Bonds

For those convinced about the merits of bonds, the next question is: How do I get started? Here are a few avenues to consider:

Direct Purchase: You can buy bonds directly through brokers, from the government (like U.S. Treasury bonds), or during new issuances in the primary market.

Bond Funds: Bond mutual funds or exchange-traded funds (ETFs) provide exposure to a diversified portfolio of bonds, which can reduce individual security risk.

Bond Ladders: This strategy involves buying bonds with staggered maturities, which can provide a more stable income stream and reduce interest rate risk over time.

Managed Accounts: Professionally managed accounts can offer tailored bond portfolios based on specific investment goals and risk tolerances for those who prefer a hands-off approach.

Wrap Up

As I prepare for my class in Frankfurt this week, I'm reminded of the critical importance of understanding bonds—not just as a standalone investment but as an integral part of a comprehensive portfolio strategy. While stocks may offer the thrill of high returns and the headlines that go with them, bonds provide stability, predictable income, and a counterbalance to the risks inherent in equity markets.

If you're heavily invested in stocks and have yet to explore the world of bonds, now might be the perfect time to start. They can provide a valuable diversification tool and offer a level of security and predictability that stocks simply cannot match. As with any investment, it's about finding the right balance that aligns with your financial goals, risk tolerance, and time horizon.

Bonds may be less glamorous than stocks, but their role in achieving long-term financial stability and success must be considered. As you consider your investment strategy moving forward, pay attention to the power of bonds to protect, preserve, and grow your wealth in a balanced and strategic manner.

I look forward to diving deeper into these topics and exploring more sophisticated bond strategies with my students in Frankfurt. If you're ready to learn more about how bonds can benefit your portfolio, I encourage you to explore further.