What Are Bonds?
A bond is a loan made by an investor to a government or company. In return, the issuer promises to pay regular interest, also called a coupon, and repay the original amount, or principal, when the bond matures. This arrangement makes bonds different from stocks, which represent ownership in a company and have returns tied to performance.
Why Bonds Matter in Investing
Bonds are one of the three main asset classes, alongside stocks and cash equivalents. They are often used to provide balance in a portfolio. While stocks can generate higher long-term growth, they are more volatile. Bonds help provide stability and predictable income. For instance, long-term U.S. government bonds have historically returned about 5% per year, while the stock market has averaged closer to 10%. This contrast shows why many investors combine both asset types.
How Bonds Work
When you purchase a bond, you lend money to the issuer. The issuer pays you interest at regular intervals until maturity. At maturity, you receive back the original investment.
Example: A $10,000 bond with a 10-year maturity and a 5% coupon rate pays $500 annually for ten years. At the end of the term, you also get back the $10,000 principal.
Bonds can also be sold before they mature. Their resale value depends largely on interest rate movements and the credit quality of the issuer.
Types of Bonds
- U.S. Treasury Issued by the federal government, considered highly reliable, but generally pays lower rates. Categories include Treasury bills (short-term), notes (medium-term), bonds (long-term), and Treasury Inflation-Protected Securities (TIPS).
- Corporate Bonds: Issued by companies. Investment-grade bonds carry lower risk and lower yields, while high-yield bonds offer higher returns but more risk of default.
- Municipal Bonds: Issued by state or local governments to fund projects like schools or infrastructure. These can provide tax advantages, as interest is often exempt from federal and sometimes state or local taxes.
Bonds vs. Stocks
Risk: Stocks carry higher risk because returns depend on company performance and market conditions. Bonds are generally less risky because payments are fixed, but they still face risks like default or inflation.
Return: Stocks have historically delivered higher average returns, around 10% annually, compared to bonds’ 5%. Bonds, however, provide consistent interest payments, which can be valuable for steady income.
Time Horizon: Stocks are better suited for investors with long-term horizons who can ride out market fluctuations. Bonds are important for those nearing financial goals or retirement, offering more predictability and stability.
Diversification: Combining both in a portfolio helps balance growth potential and risk, making it easier to weather economic cycles.
Are Bonds a Good Investment?
Bonds can be useful for anyone seeking predictable income, portfolio diversification, or lower volatility. They are often added to balance out the risks of stock-heavy portfolios. Municipal bonds may also offer tax benefits.
Still, they are not without risk. Borrowers can default, interest rates can reduce bond values, and inflation can make fixed payments less valuable. Using a mix of bonds with different maturities and issuers can help manage these risks.
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4 Key Things to Know About Bonds
- Creditworthiness Determines Interest Rates
Government bonds usually pay less because default risk is low. Companies with weaker credit ratings issue higher-yield bonds to attract investors. Rating agencies such as Moody’s and Standard & Poor’s grade these bonds. - Holding Period Matters
Bonds are issued for terms ranging from one to thirty years. Investors who sell before maturity may gain or lose depending on market conditions. Bond funds provide diversification but can be more volatile than holding an individual bond. - Interest Rates Affect Value
When rates rise, new bonds pay more, which makes existing bonds with lower rates less valuable. When rates fall, older bonds become more attractive. - Resale Is an Option
Bonds can be sold before maturity on the secondary market. Selling under favorable conditions can result in profit, while unfavorable timing may lead to losses.
