- Generally, a predictable stream of income
- Income typically higher than cash investments
- Relatively lower risk compared to stocks
- Low correlation with stock market
- Risk of default
- Bond values fluctuate with interest rates
- Generally, lower potential returns compared to stocks
Types of Investments: Bonds
How do bonds work?
When you buy a bond, you're basically buying an IOU. Bonds,
sometimes called fixed-income securities, are essentially loans to a
corporation or governmental body. The borrower (the bond issuer) typically
promises to pay the lender, or bondholder, regular interest payments until a
certain date. At that point, the bond is said to have matured. When it reaches
that maturity date, the full amount of the loan (the principal or face value)
must be repaid.
A bond typically pays a stated interest rate called the
coupon, a term that dates back to the days when a bondholder had to clip a
coupon attached to the bond and mail it in to receive each interest payment.
Most bonds pay interest on a fixed schedule, usually quarterly or semiannually,
although some pay all interest at maturity along with the principal.
There are two fundamental ways that you can profit from
owning bonds. The most obvious is the interest that bonds pay. However, you can
also make money if you sell a bond for more than you paid for it. As with any
security, bond prices move up and down in response to investor demand; they
also are sensitive to changes in interest rates. Bonds redeemed prior to maturity may be worth more or less than their original cost, and those that seek to achieve higher yields also involve a higher degree of risk.
The role of bonds in your portfolio
One of the most important reasons that investors choose
bonds is for their steady and predictable stream of income through interest
payments. Bonds have traditionally been important for retirees for this reason.
Also, though they are not risk-free--for example, a bond issuer could default
on a payment or even fail to repay the principal--bonds are considered somewhat
less risky than stocks. In part, that's because a corporation must pay interest
to bondholders before it pays dividends to its shareholders. Also, if it
declares bankruptcy or dissolves, bondholders are first in line to be
Ways to Classify Bonds
- Long-term (10+ years)
- Intermediate (1-10 years)
- Short-term (less than 1 year)
- U.S. Treasury
- Government-sponsored entities
- Foreign corporations and governments
- Investment grade
- High yield ("junk")
|By tax status
- Tax-exempt: municipal bonds (generally exempt from
- Taxable: corporate, U.S. Treasury (exempt from most
state and local tax)
The bond market often behaves very differently from stocks.
For example, when stock prices are down, investors often prefer bonds because
of their relative stability and interest payments. Also, when interest rates
are high, bond returns can be attractive enough that investors decide not to
assume the greater risk of stocks. Interest from bonds can help balance stock
fluctuations and increase a portfolio's stability. And because a bond's face
value gets repaid upon maturity, you can choose a bond that matures when you
need the money.
Some bonds are exempt from federal or state and local
income tax. This can be appealing to investors in high tax brackets.