What is a Bond?
Bonds are an asset class. When you invest in a bond, you're lending a government or business money for a set period of time, with the promise of repayment of that money plus interest.
Most investment portfolios should include some bonds, which help balance out risk over time. If stock markets plummet, bonds can help cushion the blow.
How do bonds work?
Bonds work by paying back a regular amount, also known as a “coupon rate,” and are thus referred to as a type of fixed-income security.
For example, 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.
Types of bonds
Bonds, like many investments, balance risk and reward. Typically, bonds that are lower risk will pay lower interest rates, while bonds that are riskier pay higher rates in exchange for the investor giving up some safety.
U.S. Treasury bonds
These bonds are backed by the federal government and are considered one of the safest types of investments. The flip side of these bonds are their low interest rates.
Federal bonds are in it for the long-term. They are issued in terms of 20 or 30 years.
Corporate bonds
Companies can issue corporate bonds when they need to raise money.
For example, if a company wants to build a new plant, it may issue a bond and pay a stated rate of interest to investors until the bond matures. When that happens, the company repays the investor the principal amount that was loaned.
Unlike owning stock in a company, investing in a corporate bond does not give you any ownership in the company itself.
Municipal bonds
Municipal bonds, also called munis, are issued by states, cities, counties and other nonfederal government entities.
Similar to how corporate bonds are used to fund company projects or ventures, municipal bonds are used to fund state or city projects, like building schools or highways.
Unlike corporate bonds, municipal bonds can have tax benefits. Bondholders may not have to pay federal taxes on the bond’s interest, which can lead to a lower interest rate.
Muni bonds may also be exempt from state and local taxes if they're issued in the state or city where you live.
Municipal bonds can vary in term: short-term bonds will pay back their principal in one to three years, while long-term bonds can take over ten years to mature.
The pros and cons of bonds
Pros
Bonds are relatively safe
Bonds can create a balancing force within an investment portfolio. If you have a majority invested in stocks, adding bonds can diversify your assets and lower your overall risk. And while bonds do carry some risk (such as the issuer being unable to make either interest or principal payments), they are generally much less risky than stocks.
Bonds are a form of fixed-income
Bonds pay interest at regular, predictable rates and intervals. For retirees or other individuals who like the idea of receiving regular income, bonds can be a solid asset to own.
Cons
Low interest rates
Unfortunately, with safety comes lower interest rates. Long-term government bonds have historically earned about 5% in average annual returns, while the stock market has historically returned 10% annually on average.
Some risk
Even though there is typically less risk when you invest in bonds over stocks, bonds are not risk-free. For example, there is always a chance you’ll have difficulty selling a bond you own, particularly if interest rates go up. The bond issuer may not be able to pay the investor the interest and/or principal they owe on time, which is called default risk. Inflation can also reduce your purchasing power over time, making the fixed income you receive from the bond less valuable as time goes on.
Key things to know about bonds
A bond's interest rate is tied to the creditworthiness of the issuer
U.S. government bonds are considered the safest investment. Bonds issued by state and local governments are generally considered the next-safest, followed by corporate bonds.
Treasury bonds offer a lower rate because there's less risk the federal government will go bust. A sketchy company, on the other hand, might offer a higher rate on bonds it issues because of the increased risk that the firm could fail before paying off the debt.
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.
A bond's rate is fixed at the time of the bond purchase, and interest is paid on a regular basis for the life of the bond. When the life of the bond is over, the full original investment is paid back.
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.
You can resell your bond
You don’t have to hold onto your bond until it matures, but the timing does matter.
If you sell a bond when interest rates are lower than they were when you purchased it, you may be able to make a profit. If you sell when interest rates are higher, you may take a loss.
Before you invest
Before you start investing in bonds, it's wise to make sure you have a solid monthly budget in place, have an emergency savings fund, and fully understand the risks involved.
Investing wisely in the stock market could generate financial gains in the long run. Uninformed investing, however, could cost you.
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