What Are Bonds and How Do They Work?
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Bond definition: A bond is a loan to a company or government that pays investors a fixed rate of return over a specific timeframe. Bonds are a key ingredient in a balanced portfolio.
Average returns: Long-term government bonds historically earn around 5% in average annual returns, versus the 10% historical average annual return of stocks.
Risks: A bond's risk is based mainly on the issuer's creditworthiness. Interest rates also influence a bond's value.
Advantages: The relative safety of bonds helps balance the risks associated with stock-based investments.
What is a bond?
In simple terms, a bond is loan from an investor to a borrower such as a company or government. The borrower uses the money to fund its operations, and the investor receives interest on the investment. The market value of a bond can change over time.
A bond is a fixed-income instrument, which is one of the three main asset classes, or groups of similar investments, frequently used in investing.
Most investment portfolios should include some bonds, which help balance out risk over time. If stock markets plummet, bonds can help cushion the blow.
» Learn about stocks vs. bonds
Types of bonds
Bonds, like many investments, balance risk and reward. Typically, bonds that are lower risk pay lower interest rates; bonds that are riskier pay higher rates in exchange for the investor giving up some safety. There are different types of bonds.
U.S. Treasury bonds
Treasury bonds are backed by the federal government and are considered one of the safest types of investments. The flip side of these bonds is their low interest rates. There are several types of Treasury bonds (bills, notes, bonds) that differ based upon the length of time till maturity as well as Treasury Inflation-Protected Securities or TIPS.
» Interested in giving a bond as a gift? Read all about savings 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 bonds and pay a stated rate of interest to investors until the bond matures. The company also repays the original principal.
Unlike buying stock in a company, buying a corporate bond does not give you ownership in the company.
Corporate bonds can be either high-yield or investment-grade. High-yield means they have a lower credit rating and offer higher interest rates in exchange for a higher risk of default. Investment-grade means they have a higher credit rating and pay lower interest rates due to a lower risk of default.
» Feeling sustainable? Learn about green bonds
Municipal bonds, also called munis, are issued by states, cities, counties and other nonfederal government entities. Similar to how corporate bonds fund company projects or ventures, municipal bonds fund state or city projects, like building schools or highways.
Municipal bonds can have tax benefits. Bondholders may not have to pay federal taxes on the interest, which can translate to a lower interest rate from the issuer. 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 repay their principal in one to three years, while long-term bonds can take over ten years to mature.
» Learn more about popular types of bonds
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How do bonds work?
Bonds work by paying back a regular amount to the investor, 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.
» Ready to add bonds to your portfolio? See our guide on how to buy bonds
Like any investment, bonds have pros and cons.
Pros of buying bonds
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 of buying bonds
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.
» How does inflation affect your money? Learn more about purchasing power with our inflation calculator
Are bonds a good investment?
Bonds, when used strategically alongside stocks and other assets, can be a great addition to your investment portfolio, many financial advisors say. Unlike stocks, which are purchased shares of ownership in a company, bonds are the purchase of a company or public entity’s debt obligation.
Stocks earn more interest, but they carry more risk, so the more time you have to ride out market fluctuations, the higher your concentration in stocks can be. But as you near retirement and have less time to ride out rough patches that might erode your nest egg, you'll want more bonds in your portfolio.
If you’re in your 20s, 10% of your portfolio might be in bonds; by the time you’re 65, that percentage is likely to be closer to 40% or 50%.
Another difference between stocks and bonds is the potential tax breaks, though you can get those breaks only with certain kinds of bonds, such as municipal bonds.
And even though bonds are a much safer investment than stocks, they still carry some risks, like the possibility that the borrower will go bankrupt before paying off the debt.
» Learn more: Bonds vs. CDs
4 key things to know about bonds
1. A bond's interest rate is tied to the creditworthiness of the issuer. U.S. government bonds are typically considered the safest investment. Bonds issued by state and local governments are generally considered the next-safest, followed by corporate bonds. Treasurys 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. Bonds are graded by rating agencies such as Moody’s and Standard & Poor’s; the higher the rating, the lower the risk that the borrower will default.
2. 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 — monthly, quarterly, semiannually or annually — for the life of the bond, after which the full original investment is paid back.
» Learn more: Bond ETFs
3. 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, a phenomenon called interest rate risk.
4. 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.
With bond basics under your belt, keep reading to learn more about:
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