Bonds are considered by many as too boring or too complicated. But smart investors appreciate the benefits of having a bond component in their portfolio. Most bonds provide: steady and predictable source of income; return of principal; more price stability than stocks in volatile markets; and higher return than cash over the long term.

From February to December 2002, the S&P 500 fell 20 percent; the bond market gained 9 percent. And while past performance does not guarantee future results, having even a small component of bonds in your portfolio can go a long way toward smoothing out the volatility and reducing risk within your portfolio.

The major difference between stocks and bonds is stocks make no promises about dividends or returns. Even if a company has paid dividends reliably for decades, it is under no obligation to do so. Bonds provide a steady and predictable source of income. That is where the term “fixed income” investments comes from.

The ABCs of bonds

A bond is basically a loan that the federal government, a state, a local municipality or a big company takes from the public to raise capital. The “bond” is the contract for the loan. The “issuer,” the borrower, promises to pay back the principal of the loan, plus interest. The price you pay for a bond when it is issued is its “face value” or “par.” The “maturity date” is the day the issuer promises to return your principal and the “coupon” refers to the interest payments the bond will pay in the meantime, over the “term” of the bond. The coupon amount will not change over the life of the bond. If you have a 10-year, $1,000 face value bond with a coupon rate of 7 percent, the bond will pay $70 per year for a decade, at the end of which it will also return the $1,000 principal.

While bonds are steadier than stocks, there are some risks inherent in them. The first is, you may run the risk that the bond won’t be paid back. Companies or municipalities may go bankrupt and default on their debts. U.S. Treasury bonds alone are considered “guaranteed” as they are backed by the U.S. government. (This guarantee is for the timely payment of principal and interest and, if held to maturity, provides a guaranteed return of principal.) Standard and Poor’s and Moody’s Investors Service rate companies and governments’ credit-worthiness, or their perceived ability to pay back the bonds. Entities with lower ratings will have to pay higher coupons to entice investors to purchase their bonds.

You may also run the risk that the bond will be “called” before its maturity date. That means that the issuer pays the loan back early; your principal is returned and the coupon payments stop. The bond prospectus that you receive when purchasing a bond will tell you if it is callable and when.

Inflation poses the biggest risk to bond investors. That is why good news for the economy if often seen as bad news for the bond markets; a thriving economy often raises the threat of inflation. It adversely affects bonds in two ways.

For investors who plan to buy and hold their bonds, inflation erodes the buying power of the coupon payments and the principal that will be returned at maturity. For investors who choose to not hold onto their bonds until maturity, inflation, and its accompanying rising interest rates, may cause the price the bond will get on the secondary markets to go down.

Price vs. yield

Rising interest rates and falling bond prices – that seems counterintuitive. One of the hardest concepts to understand about bonds is the inverse relationship between a bond’s “price” and its “yield.” As the price of a bond goes up, the yield goes down and vice versa. Yield is the rate of return on an investment, in the case of bonds, the interest payments, expressed as a percent. A bond’s yield is calculated by dividing the amount you receive annually in interest (the coupon) by the price you paid for the bond.

Let’s look at an example. Suppose interest rates are falling. New bonds would be issued with lower coupon rates than before, when interest rates were higher. That would make an older bond with a higher coupon more attractive, meaning investors would be willing to pay more for it. The price goes up. Say you have a $1,000 bond with a 7 percent coupon. It would pay $70 per year. If interest rates fall, a newly issued bond might pay 5 percent, or $50 per year. That means you would be willing to pay more than $1,000 for the 7 percent bond, say $1,100. Now you have paid more in order to receive the same $70; remember, the coupon does not change. You are no longer receiving a 7 percent yield on your investment. Your “yield” has fallen to 6.36 percent (70/1,100). When you pay more for the bond, the yield falls.

While it’s true that bonds, with less fluctuation and lower average long-term returns, may not be as exciting as stocks, they play an important role in building a diversified, stable portfolio. In certain markets, you can even realize a significant profit by selling bonds for more than you paid for them. If you need steady, predictable income from your investments, bonds are the way to go. Talk to your financial adviser about how you can use bonds in your portfolio.

Marc A. Pellerin is an associate vice president and investment advisor with Advest Inc. in Lewiston.