What You Need to Know About Bonds
A bond is a debt security in which investors lend money to a government or company. The company or government promises to repay the investment, the principal, and interest payments over a period. The bond then expires when the debtor reaches its maturity date.
Investing in bonds is more complex than simply buying Treasuries, though. You need to understand their complexities before making informed decisions about how to buy and hold or sell them when they mature.
Bonds are a common way to diversify your portfolio and help reduce volatility from equities. They also provide income if you hold them to maturity, and all coupon payments are reinvested at the same interest rate.
They are riskier than stocks, but their returns can be higher. They also tend to be less volatile than equities and offer the better long-term potential for growth.
There are many ways to buy and sell bonds, from individual transactions to professionally managed mutual funds or exchange-traded funds (ETFs). However, some things you need to know before investing in bonds include their basic terms, the role of bonds in your portfolio, and the associated benefits and risks.
What You Need to Know About the Terms and Terminologies of Bonds The terms used when discussing bonds are similar to those used when discussing other investments, like equities or commodities. They include the issuer, the coupon, the face value, and the maturities of the bonds.
Unlike stocks, which can be sold on the market or to your financial professional, bonds must be bought through the secondary market. They are typically purchased from a broker, through an exchange-traded fund, directly from the U.S. Treasury, or via a 401(k) plan, if available. They are usually issued by governments, corporations, and other entities, although some non-profits and certain municipalities are considered conduit borrowers. Conduit borrowers, like hospitals and universities, do not have to pay back their bonds if they fail to meet their obligations. Generally, bonds are longer-term investments than stocks because they have more time to mature before the company or government repays your investment. However, this also means that you will earn more interest but incur additional risk if the interest rate rises too quickly. Maturity dates are also different, but the same rules apply. They can be short-term (one to three years), medium-term (over 10 years), or long-term (over 30 years).
Ratings are a good way to determine the creditworthiness of bonds and the level of risk involved. The higher a bond’s rating, the less likely it is to default. A bond with a low rating has the highest risk of default and should be avoided.
Inflation risk is a major factor in purchasing a bond. If inflation exceeds a bond’s fixed income, the investor loses their purchasing power.
In addition, bonds can be expensive to buy and depreciate over time. Because of these risks, it is best to purchase them in small amounts and hold them for a long time before selling them. If you are unsure whether bonds will be a good investment, talk to your financial adviser.