Your Investments: Bonds in times of volatility

As the wild ride for financial markets continues, investors are looking for ways to stabilize their portfolios. One way of accomplishing this is through the use of bonds.
What are bonds?
A bond is essentially a loan or an IOU issued by a corporation, government or government agency. When a person buys a bond, he is basically loaning money to the issuer. In return, the bondholder expects to receive his money back when the bond matures (the agreed-upon date for the issuer to repay the principal), as well as receiving interest payments that are usually paid semiannually.
How does it work?
An example of this occurs when a company such as Microsoft issues a bond that matures in four years at a fixed interest rate of 5 percent, payable semiannually. If a person invests $10,000 into this bond, he will either receive $250 every six months or $500 annually. In four years, Microsoft will repay the original $10,000 to the investor as well. Note that the guarantee to pay interest and principal at maturity comes from the issuer of the bond. In this example, if Microsoft would be unable to meet its obligations, the bond would default, and the bondholder would lose some or all of their money, receiving neither interest nor principal.
Bonds are liquid investments, so that the bondholder does not have to hold on to it until it matures but can sell it whenever he wants, at which point he receives the interest that has accrued to that point. However, in this case there is no guarantee of principal, and the bond will be sold at the market price, which may be higher or lower than the initial purchase price.
Bond prices
Two main issues affect the prices of a bond. Bonds move in response to the credit quality/financial situation of the issuer and shifts in interest rates. With corporate bonds, changes in the company's financials can both positively and negatively impact the price. Changes in interest rates usually have the most impact on bond prices. Here's how. Bear with me as this is a bit complicated.
There is an inverse relationship between changes in interest rates and bond prices. When interest rates decline, the price of existing bonds usually rises, and when interest rates climb, prices usually fall. The reason for this can be explained using the example of the 5% Microsoft bond given above. If interest rates fall, the 5% received on this bond becomes more attractive, and as the demand for the bond increases, so does the price. Conversely, if interest rates move up, suddenly the 5% isn't as attractive as it was when rates were lower, so the price of the bond drops.
Are they safe?
As it's almost impossible for the average investor to know the financial situation of thousands of different companies before being able to make an informed decision about which bonds to buy, a rating system was developed. This system uses the letters A, B, C and D to help investors know the financial stability of the issuer.
There are a few well-known, independent organizations that provide these ratings. Standard and Poor's and Moody's are the most well-known, and they have many research analysts who analyze the financial state of each company in great detail before assigning a rating to the company's financial stability.
It's important to note that the analysts cannot predict the future, and even though a bond might receive a high rating, it could still default for any of a number of reasons. Just ask bondholders of Lehman Brothers whose bonds had a high rating even as they declared bankruptcy.
Bonds are attractive because they pay steady income. An investor knows that on a specific date he will receive a fixed sum of money. This can be important for retirees because they can create a portfolio to generate enough income to meet their standard of living. Since bonds can appreciate (and depreciate) in value, you can also buy and sell bonds for capital gains.
Many Torah-observant Jews prefer to be careful when it comes to the halachot of ribbis (interest) and heter iska (rabbinical formula for permitting interest charges). With regard to investing in Israeli corporate bonds, it is therefore very important to consult a rabbi to make sure there are no halachic issues. It can be easier to invest in bonds abroad because most of the companies aren't owned by Jews, and there is a larger choice of bonds to buy.
Aaron Katsman is a licensed financial adviser, both in the United States and Israel, and helps people who open investment accounts in the US.