If you’ve been reading up until this point, you’ve probably seen the word bond come up a couple of times. What exactly are bonds, and how are they different from stocks, you ask? Well, while a stock represents ownership in a company, a bond represents a company or organization’s debt to you. A bond is like an IOU, stating that you have lent your money to a company or organization in return for their commitment to repay you after a certain period of time when the bond matures. There is usually a commitment to pay you a specified amount of interest for the duration of the investment. That’s the main thing to remember when comparing a bond to a stock. Bonds represent money owed to you, with a (usually) specified amount of interest, so bonds are generally lower risk investments than stocks. Of course, the return on bonds is limited and not as high as the returns you can potential get on the stock market, because of the lower risk.
Why is investing in bonds useful?Bonds are useful because they limit risk. In a balanced portfolio you don’t want all your investments to be volatile. You should ideally have a good base of lower risk investments, including bonds, and stable stocks and mutual funds (preferably index funds), as well as some higher risk investments to increase your potential gains. Bonds are one way to limit risk, and can cushion your losses if the markets suddenly drop. Another benefit of bonds is that they bring in a predictable income, which is useful in planning your financial future. You (usually) know that you will get back your premium (the money you originally invested) plus the fixed interest. Some bonds pay interest every six months, giving you a regular stream of income, while other bonds called zero coupon bonds pay you all the interest when the bond matures, which has the benefit of compounding interest.
The interest rate on bonds is usually fixed. If there is a fixed interest rate of 8%, then on a $1000 bond you will recieve $80 of interest per year. There are some stocks with a floating interest rate, which means that the rate may change in line with economic trends. But this doesn’t affect the investment principal. Interest rates can vary depending on the length of the contract. Short term bonds provide more stability and less exposure to risk, but have lower interest rates (by now you should be used to that idea that low risk = low return). Longer term bonds involve more risk, because if you have purchased a bond with a fixed interest rate and then interest rates rise sharply, you have missed an opportunity to receive a higher interest rate on your investment. Because of this risk, longer term bonds will usually have a somewhat higher interest rate than short term bonds.
There are a few other considerations to keep in mind when choosing which bonds to purchase. One is the bond`s redemptive features, determining if either party has the right to cancel the contract before the date of maturity. A call provision gives the issuer of the bond the right to repay the investment principal early and cancel the contract. This typically happens when interest rates fall sharply, so that the issuer is no longer willing to pay you the originally agreed to interest rate they agreed to. They`d rather cancel the contract and find new investors at a lower interest rate. A put is the converse of a call, meaning that the investor can choose to sell the bond back to the issuer early. This typically happens when interest rates have risen sharply, and the investor can reinvest that money at a higher interest rate. Check the conditions for possible early redemption before purchasing a bond.
One more consideration is the stability of the bond issuer. Is the investment backed by a stable government? Buying a third world country`s government-issued bond is obviously riskier than buying a US Treasury bond. Does the issuer have a stable credit rating? Bond issuers are rated by various agencies according to their financial condition. Under Standard and Poor`s rating system, bond issuers deemed BBB category and higher are considered investment grade, with a strong expectation that the bond will reach maturity. Issuers deemed BB grade and lower are labelled high yield, providing a higher interest rate but posing a small risk of default. Remember that diversification is of central importance in minimizing risk, and that it`s much better to hold a diversified portfolio of high yield bonds than just one high yield bond! Note that high yield bonds are sometimes referred to as junk bonds, but that name should not be taken literally because higher risk does not automatically qualify an investment as `junk`.
Bonds are sold with a face value, that represents the original value and price of the bond, as well as a pre-determined interest rate. If you buy the bond immediately after its released, then you should be paying the face value. But like stocks, the prices of bonds can fluctuate, largely due to fluctuating interest rates. For example, if a bond had a fixed interest rate of 6%, but then market interest rates dropped way down to 2% or 3%, a lot of investors would be anxious to get a piece of that fixed 6% interest rate. In response to that new demand for the bond, the price would rise. But you would be getting a higher interest rate than you could get elsewhere, so the fluctuating price and the changing interest rates can be said to balance each other out.
Investing in bonds may not be as exciting or as potentially lucrative as madly fluctuating stocks and funds, but they limit risk and offer stability and predictability, and are an essential part of a balanced portfolio.