Bonds: Give me shelter

Mention investing at your next dinner party and guests will merrily chat about the stocks they like. But bonds? Nobody ever sat around a bottle of wine swapping bond picks. Bonds are dull, the investing world’s equivalent of mashed potatoes.

At least that’s what most people think. Stick a fork beneath the surface, however, and you’ll discover that bonds aren’t so dull after all. In fact, they can be just as tempting as stocks. Despite what most people think, Canadian bonds have produced virtually identical results to Canadian stocks over the past 25 years. Bonds gained 10.6% a year during that period, while stocks advanced 10.7%.

If you’re just beginning to invest, it’s important to appreciate the differences between stocks and bonds. When you buy a stock, you’re buying a tiny slice of a company. If the company does well, the stock price rises and you make money. On the other hand, if the company runs into problems, you suffer a loss.

When you buy a bond, the situation is different. You’re not signing on as an owner. All you’re doing is lending the company a bit of cash. A bond is an IOU in which the company promises to pay you a set amount to use your cash for a certain number of years. You won’t get any extra payout if the company does spectacularly well. But if the company hits a snag, you can take comfort in knowing that its problems don’t affect you. So long as the company can continue to makes its bond payments, your cash keeps rolling in.

Bonds deserve your attention because they provide a natural balance to the ups and downs of the stock market. When economic news is good, bonds fall. Conversely, when times turn bad, bonds rise.

Bonds move in this odd way because the guaranteed payout from a bond becomes more valuable as the investing alternatives grow worse. Think of a bond as being like the emergency rations you keep tucked away in a kitchen drawer. During normal times, when you can wheel by the supermarket to get dinner, your food cache isn’t worth much. But if there’s a huge snowstorm that blocks the roads for days, the value of your stash skyrockets.

Bonds are at their best when there’s a financial storm. That’s why wise investors keep 25% to 50% of their investment portfolio in bonds. If the economy goes bad and stocks sour, bonds provide you with hearty fare until the storm blows over.

Most of us invest in bonds through bond mutual funds. Two tips can help make sure you get the best deal on these funds:

Watch fees. Since bonds yield only 5% or so, paying a 2% management fee on a bond fund can eat up nearly half your profits. Consider instead the iShares Canadian Bond Index ETF . This trades on the Toronto Exchange under the ticker XBB . It charges you a mere 0.30% a year to track the Canadian bond market.

Watch risk. Some bonds are riskier than others because the companies behind them are financially weak. Rating agencies rank bonds on a scale ranging from AAA (super solid) to C (close to default). If in doubt, stick to funds that buy mostly bonds rated AA and AAA. They’re solid fare for any investor’s table.