Not to be confused with stocks, which are purchased portions of ownership in a business, bonds are an investment in debt obligation. When you buy a bond, you loan money to a corporation, government or other entity. In exchange, the public entity promises to repay you after predetermined a period with interest.
Organizations like businesses and federal and local governments rely on bonds to raise capital. Businesses may use bonds to complete projects, hire new talent, purchase property or address other business needs. Governments, on the other hand, rely on bonds to fund the projects like the construction of roads and schools or support military needs. When the costs of such undertakings exceed the money an average bank can supply, corporations and governments may invite individual investors, such as yourself, to become lenders by investing in bonds.
Because bonds carry a fixed rate of return, they are sometimes called “fixed-income securities” and considered to be a safer investment than stocks. However, as with all investments, bonds do come with some potential pitfalls.
How do bonds work?
When you purchase a bond from a government or corporation, you loan them money for a predetermined period. The borrower agrees to pay you back on a certain date, known as the “maturity date.” The original amount you loaned the borrower that is paid back on maturity is referred to as the “face value.”
In the meantime, the bond issuer pays interest to you in the form of routine payments at an agreed-upon schedule and rate. The interest rate of a bond is sometimes called “coupon” or “yield”.
Even though the issuing price of a bond is fixed, the actual market value of the bond may rise and fall before it reaches maturity. The current market price of a bond may be below or above its face level, depending on factors like the issuer’s credit and economy interest rates.
Different Types of Bonds
There are many different types of bonds issued by different types of issuers. See examples of some of the most common types of bonds below.
- Government bonds
- Corporate bonds
- Asset-backed securities
- Mortgage-backed securities
Government bonds are bonds issued by national governments and lower-level governments like states. U.S. government bonds, sometimes called treasuries, are typically one of the safest types of investments before bonds issued by state and local governments. Corporate bonds are the most common type of bond and are issued by companies.
Asset-backed securities (ABS) are issued by financial institutions like banks. Asset-backed securities are backed by financial assets like credit card receivables, auto loans and home equity loans. Mortgage-backed securities are types of bonds similar to asset-backed securities but backed by a collection of mortgages instead of other assets.
Benefits of Bonds
As an investor, there are many advantages to including bonds in your portfolio. The volatility of most bonds is less than that of stocks, making them a comparatively low-risk investment. Rather than buying equity as you do when you purchase stock, you invest in debt when you buy a bond Debt is generally considered a more secure investment. Should the company you invest in go bankrupt, you will receive a payout before stockholders.
Bonds provide a steady, dependable source of income. By purchasing bonds, you can predict with a better level of certainty how much you will receive in income over the years compared to stocks. This makes bonds a good choice for investors like retirees who live off their investment interest.
As any seasoned investor will tell you, it is essential to diversity your portfolio by investing in different companies, industries and asset classes like stocks and bonds. Stocks, bonds and other assets will react differently to market events. Often, stock and bond markets will move in opposite ways, so if you include both asset types in your portfolio, one adverse outcome in one market will be counterbalanced by a gain in the other.
In most cases, the interest you earn on bonds is higher than the interest you would earn by putting your money in a savings account. This makes bonds a safe way to invest your money long-term with higher returns than simply stowing it away in a bank.
Municipal bonds, or bonds issued by state and local governments, provide interest payments that exempt from federal taxes. If you buy a municipal bond issued by your state or city of residence, their interest payments may also be exempt from state and local taxes.
Drawbacks of bonds
Even though bonds are considered a safe investment compared to stocks, they also carry their share of risks and downsides. Because bonds are a low-risk investment, they carry a low rate of return compared to stocks and other investments like real estate. While low-interest bonds may perform better than bad stocks, the return on a bond is tends to be much lower than a stock investment. For this reason, bonds may not be the best choice if you are seeking to grow your investment substantially or quickly.
Though the interest rate and face price of a bond are fixed, a bond’s market price can be volatile depending on the credit rating of the borrowing entity. If a bond issuer’s credit score drops, this could cause the market price of the bond to drop with it. If you were planning to sell before the bond reaches maturity, this might mean selling it at a lower price than what you invested.
If a company goes bankrupt, there is a possibility that you could lose all your money if you are a bondholder. Companies that go bankrupt may have to pay banks, trade creditors and deposit holders before bondholders receive anything.
Select bonds are callable, which means that the bond issuer can elect to pay their debt in full before the bond reaches maturity. If this occurs when interest rates are falling, you may have to reinvest your money in a less attractive asset.
Despite their disadvantages, bonds are generally a safe, dependable way to invest and a vital part of a diversified portfolio. Bonds are a particularly useful tool for investors who plan to live off interest, such as retirees. It is advisable to add more bonds to your portfolio as you draw closer to retirement.