Investing Basics: Bonds

Bonds are a common investment. However, to many investors, they remain a mystery. So, let's explore what a bond is and how it might benefit your investment portfolio.

A bond is a loan given to a company or government by an investor. By issuing a bond, a company or government borrows money from investors, who, in return, are paid interest on the money they've loaned. Companies and governments issue bonds frequently to fund new projects or ongoing expenses.

Some investors use bonds in hopes of preserving the money they have while also generating additional income. Bonds are often viewed as a less risky alternative to stocks and are sometimes used to diversify a portfolio. Consider this example… The hypothetical city of Fairview wants to build a new baseball stadium, so it decides to issue bonds to raise money.

Each bond is a loan for $1,000, which Fairview promises to pay back in 10 years. To make this loan more attractive to investors, Fairview agrees to pay an annual interest rate of 2%, which in the bond world is also known as a coupon rate. An investor buys the bond at "face value" for $1,000.

Now let's fast-forward. Each year, the city of Fairview pays the investor $20. These regular interest payments continue for the length of the bond, which is 10 years.

Once the bond reaches maturity, the investor redeems his bond and Fairview returns his $1,000 principal investment. This bond was a good deal for both the city and our investor. Fairview got the money it needed to build the stadium.

The investor received regular interest payments and the return of the original investment. Because a bond offers regularly scheduled payments and the return of invested principal, bonds are often viewed as a more predictable and stable form of investing. Compare regular payments of a bond to the experience of owning a stock.

With stocks, profits and losses are driven by market forces and are generally less predictable. Of course, like any investment, bonds are not without risk. One risk that bond investors face is the possibility that the issuer defaults on paying back the principal.

This is what is known as "default risk". Typically, bonds with higher default risk also come with higher rates of return, also known as yield. The amount of risk depends mostly on the financial stability of the issuer.

For example, many governments are generally considered stable issuers and issue bonds with a relatively low yield. Corporate bonds typically represent a greater risk of default. That's why corporate bonds often offer a higher coupon rate.

Several credit rating agencies assign ratings to different bonds. This can help bond investors gauge the financial strength of the bond issuer. These rating agencies often use different criteria for measuring risk, so it's a good idea to compare ratings when considering a particular bond.

And keep in mind, rating agencies aren't always accurate, so be sure to research a bond and its risks thoroughly before investing. Another risk to consider is interest rate risk. This is the risk that interest rates will go up, and any bonds you own will be worth less if sold before their maturity date.

After all, when interest rates rise, more investors allocate their money into the new, higher interest-rate bonds. If you wanted to unload a low-interest rate bond to take advantage of these new rates, you'd have to sell your bond at a lower price than what you bought it at to make it a worthwhile purchase for another investor. Capital preservation and income generation are just two ways bonds might be part of a diversified portfolio.

Many investors use a mix of stocks and bonds to pursue their investment goals, and because bonds move differently from stocks, they can help increase or protect portfolio returns. Keep in mind that this discussion showed you one simplified way that investors might use bonds and only a few of the risks to consider. Like all investments, bonds are complex and have a variety of uses and risks.

Before you invest in bonds, it's important that you invest in your own financial education.