What are Bonds?
The government or companies raise money in two common ways. They can either borrow the money (like loan) or sell a piece of ownership in the company through stock. Bonds are basically a way to raise capital through borrowing money, like an IOU (I Owe U – informal document acknowledging debt). Unlike loan documents issued with a bank loan or credit card debt, the bond borrower give lenders a certificate that can be exchanged to other investors. In modern times, bonds are mostly traded electronically. Lenders could also go to the bank with an actual certificate to cash out interest and principal payments.
Since bonds can be exchanged, they are considered securities that can be securely bought and sold in public market places — it is a huge market with liquidity. Matter of fact, the US Bond Market is the largest securities market, including stocks or future commodities.
Bonds as an Investment
Bonds are distinctive in two aspects. It is important to realize that bonds do not provide a high rate of return as compared to individual stocks or mutual funds but are typically secure with a low risk and high probability that the investment will not lose value.
- The borrowers agrees to pay a fixed rate of interest (this is called the coupon), at fixed intervals and at a fixed period of time. For example, a company agrees to raise $500 million through a bond offering. An investor would be considered the lender as they purchase the bonds from the company. Depending on the terms of the bond, the company will repay the lender over time the interest. When the bond matures (expires), the company will pay back the initial investment (known as the Principal, Face Value, or Par Value).
- A majority of bonds are senior securities, meaning that if a company or government runs into money issues, the bondholders are the first to get repaid before shareholders, which makes this a safer investment than stocks. However, taxes and bank loans must be paid before bondholders.
United States government bonds are considered the safest investment. Also known as treasury’s, these bonds are backed the “full faith and credit” of the United States. The next safest investments are state and local government bonds, followed by corporate bonds.
Bonds are graded by rating agencies such as Moody’s Corporation and Standard & Poor’s. The bonds with higher rating come with less risk that the bond issuer will default on repayment.
The credit rating decides the interest rate of a bond. Treasury’s, the safest form of bond, offer lower rates because they are the safest type of bond investment. This is because it is not likely that the federal government will collapse. Contrast, a company with no reputation would have to offer a higher interest rate because of the increased risk that the company could tank before maturity.
Bonds are a type of fixed-income security.
Since this speculation pays back a customary sum, otherwise called a “coupon rate,” it gives a solid return, inasmuch as the backer doesn’t default. So a $10,000 bond with a 10-year maturity date and a coupon rate of 5% would pay $500 a year for a decade, after which the original $10,000 face value of the bond is paid back to the investor.
How long you hold onto a bond matters.
Bonds are sold for a fixed term, typically from one year to 30 years. You can sell a bond on the secondary market before it matures, but you run the risk of not making back your original investment or “principal.” Alternatively, many investors buy into a bond fund that pools a variety of bonds in order to diversify their portfolio. But these funds are more volatile because they don’t have a fixed price or interest rate.
Bonds often lose market value when interest rates rise.
As interest rates climb, so do the coupon rates of new bonds hitting the market. That makes the purchase of new bonds more attractive and diminishes the resale value of older bonds stuck at a lower interest rate.
What’s in it for you?
Bonds are a key ingredient in a balanced portfolio.
Most investment portfolios should include some bonds, which help balance out risks over time. If stock markets plummet, bonds can help cushion the blow.
The closer to retirement, the more bonds you want — generally.
Stocks pay higher returns if you have the time to ride out market fluctuations. As you near retirement, you have less time to ride out rough patches that might erode your nest egg. If you’re in your 20s, 10% of your portfolio might be in bonds; by the time you’re 65, that percentage is likely to be closer to 40% or 50%.
Interest payments on municipal bonds aren’t subject to federal taxes.
Also known as “muni bonds,” they are issued by state and local governments to help fund public projects like construction of schools. Muni bonds also may be exempt from state and local taxes if they’re issued in the state or city where you live.