What Are Bonds?
A bond is a debt security. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency, private individual or other organization known as an issuer. In return for the money, the issuer agrees to pay a specified rate of interest during the life of the bond and to repay the face value of the bond when it matures.
There are lots of different types of bonds available for investment: U.S. government securities, municipal bonds, corporate bonds, mortgage/asset-backed securities and federal agency securities are just a few. Bonds can be also called bills, notes, debt securities, or debt obligations.
Certificates of deposit (CDs) or short term commercial paper are what are considered money market products. They don’t have the same terms as bonds and tend to behave a little more like cash than bonds do. There are also differences in the length of the securities.
Why Invest in Bonds?
Many personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. Whatever your investment goals, bonds can play an important role in your portfolio, taking into account your income needs and risk tolerance.
Typically, bonds pay interest semiannually which means they can provide a regular and predictable income stream. Many people invest in bonds for that expected interest income, to preserve their capital investment or as part of a speculative investment strategy. Understanding the role bonds play in a diversified investment portfolio is especially important for optimizing your finances. Whatever the purpose—saving for your children’s college education or a new home, increasing your income or any of a number of other financial goals—investing in bonds can help you achieve your objectives.
Risk, Prices and Interest Payments
Risk: Bonds carry some degree of risk, which is linked to the return that the bond will provide. A good rule of thumb is the higher the risk, the higher the expected return. There are a number of key variables that make up the risk profile of a bond. These include: its price, yield, maturity, redemption features, credit rating and tax status. Macroeconomic conditions and interest rates play a large role also. Together, these factors determine the value of your bonds.
Price: The price you pay for a bond is based on a whole ton of variables, including interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds normally sell at close to 100 percent of the face value. Bonds traded in the secondary or open market tend to fluctuate in price to changing interest rates, variations in credit quality, general economic conditions and supply and demand. When the price of a bond increases above its face value, it is selling at a premium. When a bond sells below face value, it is selling at a discount.
Interest Payments: Bonds typically pay fixed, variable or payable at maturity interest payments. The interest rate usually stays fixed until maturity and is a percentage of the face amount; say 3% or 4%. This interest rate is usually fixed when the bonds are first issued. To illustrate, a $10,000 bond with a four percent interest rate will pay investors $400 a year, two payments of $200 every six months. The $200 payment is called the coupon payment. When the bond matures, investors receive the full face amount of the bond, $10,000.