No matter your age or financial situation, investing in fixed-income investments - or bonds - can provide a potentially stable and reliable source of income while diversifying your portfolio.
What is a bond?
A bond is a loan an investor makes to an issuer of the bond. Just like a bank lends money to a person, a bond investor agrees to lend money to a government, municipality, corporation or other type of issuer. These loans charge a set interest rate, known as a coupon rate (which is shown as a percentage), for a certain period of time.
The coupon rate is usually determined by length of the loan (term) and the issuer’s ability to repay the bond’s principal and interest. At the end of the loan’s term (its maturity), a bondholder will receive the bond’s face value (principal and/or par value). The income that an investor receives for owning the bond is calculated by multiplying the bond’s coupon rate times its par value. For example, a $1,000 par bond with a 5% interest rate will provide $50.00 in annual income, or $25.00 in income paid semiannually.
How are bonds different from stocks?
When you buy a stock, you’re buying a fractional share of a company and a share in the future earnings of the firm. On the other hand, bonds don’t represent a fractional share of the firm and are backed by assets of the issuer – including buildings, factories and inventory. If a company files bankruptcy or liquidates, a stock holder is unsecured and may receive nothing while a bond holder may have preference on proceeds from the sale of company assets. This is generally one of the reasons why bonds are considered a safer investment than stocks.
What are the types of bonds?
Bonds make up the world’s largest securities market, and they can provide you with a variety of investment options depending on your goals, how much risk you’re comfortable with and your time horizon. Here are some common types of bonds:
- Government bonds: Also known as “Treasuries,” these bonds are issued by the federal government with maturities ranging from a few months to 30 years. U.S. Treasuries are backed by the full faith and credit of the government, making them the highest-quality fixed-income securities.
- Municipal bonds: Issued by states, cities and other local governmental entities, “munis” help finance projects or other municipal activities. Some municipal securities offer a tax-efficient means of generating income.
- Corporate bonds: Debt issued by corporations for a wide range of strategic investments, such as new equipment or a factory. Corporate bonds are often considered higher-risk investments than most government or municipal bonds. Bonds issued by companies with the lowest risk, or highest credit quality, are known as “investment grade.” Debt issued by higher-risk companies, which often have lower credit quality and higher yields, are known as “speculative grade” or “high-yield” bonds.
Should you consider bonds?
Fixed-income investments can help diversify your portfolio and reduce overall risk and volatility. They can also contribute to your portfolio’s long-term performance because you can either keep the income your bonds generate or reinvest it into other securities. You can also use bonds as an extra source of income. Some bonds, known as tax-exempt municipal bonds, can provide tax advantages.
Bonds offer many benefits for investors but they’re not risk-free. Investing in bonds with the help of a professional money manager, like through a mutual fund, can help reduce risks. Portfolio managers have access to experienced senior analysts and traders who examine individual bonds more closely than private investors. Bond funds also give you automatic diversification because they usually hold hundreds of different bonds with various maturities, issuers and risk profiles.
However, holding bonds in a mutual fund portfolio can also increase the volatility of your holding and affect the tax impact of income received.