What Are Bonds?
Bonds are marketable securities that represent a loan to a company, a municipality, the federal government, or a foreign government with the expectation that the loan will be paid back at a set date in the future. Like almost all loans, bonds also come with an interest component, which can involve periodic payments over the life of the bond or single payments at maturity. Bonds can be bought directly as new issues from the government, from a municipality, or from a company. They can also be bought from bond traders, brokers, or dealers on the secondary market. The bond market dictates how easily you can buy or sell a bond, and at what price.
A big part of the bond picture is interest: for lending them the money, the borrower (or issuer of the bond) agrees to pay the buyer a specific rate of interest at predetermined intervals. Bonds are sold in discrete increments (typically multiples of $1,000, with few exceptions), known as their par value or face value. Their maturities range from short-term (up to five years) to intermediate-term (generally seven to ten years) to long-term (usually around twenty to thirty years). Longer-term bonds typically will pay higher interest rates — averaging higher than 6 percent over the last fifty years — than short-term bonds. Though the bond's stated interest rate is a known factor, over the time its yield (or effective interest rate) will fluctuate along with changes in prevailing interest rates; this matters primarily if you are trying to sell a bond.
Because bond values often move in the opposite direction of the stock market, bonds can be a key component in both the risk-reducing diversification and asset allocation strategies essential for good portfolio management. While bonds typically don't function as a complete substitute for stocks, they do make a strong complement, in addition to providing steady interest income to investors.
A bond will have a date of final maturity, which is the date at which the bond will return your principal, or initial investment. Some types of bonds — known as callable bonds — can be redeemed by the issuer earlier than that maturity date, which means that the lender pays you back sooner than expected. A $5,000 bond is worth $5,000 upon maturity (regardless of the price that bond would fetch on the open market), as long as the issuer does not default on the payment. The interest you receive while holding the bond is your perk, so to speak, for lending the money. Interest is usually paid semiannually or annually, and it compounds at different rates.
Bonds versus Stocks
Unlike a stockholder, a bondholder does not take part in the success or failure of the company. Shares of stock will rise and fall in conjunction with the company's fortunes. In the case of bonds, you will receive interest on your loan and get your principal back at the date of maturity regardless of how well a company fares — unless, of course, they go bankrupt. Bonds are therefore referred to as fixed-income investments because you know how much you will earn — unless you sell before maturity, in which case the market determines the price.
Corporate bond prices, like stock prices, can be affected by corporate earnings. However, they are often affected to a much stronger degree by fluctuations in interest rates. This is true even though the bond market itself often takes the lead in setting those rates. And both types of securities are subject to influences like terrorism, politics, and fraud.
When you're considering a bond for your portfolio, remember to analyze these seven key features: price, stated interest rate, current yield, maturity, redemption features, credit rating, and income tax impact. Together, these factors can help you decide whether this bond fits into your portfolio and meshes with your personal investment goals.
As a general rule, bonds, particularly U.S. government bonds, are considered less risky than stocks and are therefore considered a more conservative investment. Bonds also tend to provide a higher rate of interest than you can get from a bank account or CD, and this, along with a steady flow of interest income, usually makes them attractive, relatively safe investments.
There are drawbacks and risks inherent to bonds, which will also be discussed in more detail later in this chapter. The most basic risk is that an issuer may default, meaning you will not get your money back. You can also lose money in bonds if you are forced to sell when interest rates are high. And you may not see the type of high returns from bond investments that you can realize from more risky equity mutual funds or from a hot stock.