Every investor should consider fixed-income assets – that is to say, bonds – to be an important part of their portfolio. Holding all your money in the stock market is risky – even the best companies can get their share value trampled in a general panic, and disastrous one-off events can ruin a formerly blue-chip stock like BP.
Bonds are, effectively, debts – the bond issuer receives a fixed amount of money in exchange for a promise to repay that cash, plus a certain amount of interest. The riskier the loan, the higher the interest rate, also known as the ‘coupon’ from the days when bondholders actually received physical pieces of paper and mailed in individual coupons to receive their interest payments.
So it’s that simple, right? Not quite – bonds, like all other assets, exist in an ever-changing world. Nothing has static value, not even cold, hard cash; currencies fluctuate based on inflation and the foreign exchange markets. So bonds rise and sink in value each day as well, as traders try to figure out which are overvalued and which are undervalued. The infamous Sherman McCoy, the "Master of the Universe" at the center of Tom Wolfe’s seminal The Bonfire of the Vanities was a bond trader, if a somewhat exaggerated one.
The yield, then, is the return you get when you buy a bond. Different investors can get different yields on the same bond, if they buy at different prices. Of course, holding the debt will always give you the same yield, equal to the interest rate – a 10 percent bond with a maturity of 10 years will yield 10 percent at the end of that period.
However, what if the company which issued the bond – BP, say – suffers some catastrophe in the intervening period. Some investors may decide BP is a bigger repayment risk than they thought. They may sell their bonds below the original value. You might be able to buy a bond with a face value of $500 for just $450, yet it will still pay 10 percent interest. The yield you get for buying this bond will go up in this case, as you get the same guaranteed return for a discounted price.
The savvy young bond investor, then, will get into the market when attitudes are generally pessimistic, and buy bonds with higher yields. Then, you can either hold them to maturity, when they pay out – or sell them to someone else when the price goes back up and the yield decreases.