Bonds are loans or IOUs – a kind of debt, but rather than you owning the bank, you play the role of the bank. You lend money to the government, a company, a city, etc. – and in turn, they agree to pay you back in full, along with regular interest payments.
A city might want to sell bonds in order to raise adequate fund to build a new stretch of road or to build a new bridge, while the federal government issues bonds to take care of the finances that are necessary for the spiraling debts the country could be facing.
Investors who are nervous will generally head towards the safety of bonds and the steady income — this is especially true during times when the stock market is increasingly volatile. Younger investors should put aside 15% or less of their investment income for retirement, depending on your goals, age, and tolerance for risk. Bonds are a good way to balance out any riskier stock investments you might have.
How safe are bonds?
That does not mean bonds are risk-free – in fact, nothing could be further from the truth. Some bonds are very dicey. As with all kinds of investments, the riskier the investment, the more you are paid. With bonds, that risk comes in a few different forms.
The first is the probability that the bond issuer will not make the payments as was agreed upon. When the issuer is not as credit-worthy, they will pay a higher interest rate or yield. This is the reason why the riskiest issuers offer what’s referred to as “junk” bonds or high-yield bonds. Those bonds with the best histories at the top of the spectrum are considered investment-grade bonds.
The safest bonds are issued by the U.S. government, and these are known as Treasuries, which are backed by the U.S “full faith and credit,” and deemed virtually risk-free. A Treasury bond pays a lower yield than a bond that has been issued by a storied company, such as Johnson & Johnson.
What else is important with bonds?
The length of time you hold the bond, which is how long your money is made available to the bond issuer, also plays a role. Bonds with longer durations, such as a 10-year bond, will pay a higher yield because you are paid for keeping your money tied up for a longer period of time.
However, for the most part, interest rates have the single largest effect on bond prices. As the interest rates go up, bond prices fall because when interest rates are up, any new bonds are issued at the higher rate, which makes bonds that already exist with lower interest rates less valuable.
If you hang onto your bond until it matures, price fluctuations won’t matter. Your interest rate was established at the time you made your bond purchase, and once the term is up, you receive the face value (which is your initial investment of the bond) back and the agreed upon interest. However, if you decide to sell your bond on the secondary market prior its maturity date, you may get less than your original investment back.
Up to this point, we have discussed individual bonds. Bond funds or mutual funds that invest in bonds are slightly different. With bond funds, there is no maturity date so the amount you invested fluctuates and so will the interest payments.
So why worry yourself with a bond fund? You need a large chunk of money if you are going to build an individual bonds portfolio that is diversified. The type of bond portfolio you are looking to build will define how much money you need to invest. You may need tens of thousands of dollars if you want to do it right. Meanwhile, bond funds give instant diversification.
Issued by the U.S. government, these are believed to be the safest bonds available on the market. As a result, you won’t earn as much interest as you could, but you will not have to concern yourself with defaults. They are the benchmark that is used to price all other bonds, like those that are issued by municipalities and companies.
Treasuries are available in $1,000 increments and are initially sold through auctions, where the price of the bond is determined.
Also known as T-bills, these short-term investments are sold in terms that range from a few days up to 26 weeks. They are sold at a discount, but once the T-bills mature, you can redeem them at their full face value.
Issued in either 2, 5, or 10-year terms and in $1,000 increments. Mortgage rates are priced off of the 10-year bond, even though technically it is a note.
Issued in 30-year terms. They pay interest every 6 months until they mature.
Treasury inflation-protected securities
These will protect your portfolio against inflation and generally pay a lower interest rate than other Treasuries, but the principal and interest payments are adjusted with inflation as measured by the Consumer Price Index.
It is best to have these held in a tax-deferred account, like an individual retirement account or IRA, because you will have to pay federal taxes on the increase in the underlying principal, even though the principal doesn’t come back until maturity.
When TIPS do mature, you, as the investor, receive either the original principal or adjusted principal, whichever is greater. TIPS are sold as 5, 10, and 20-year terms.
EE Savings Bonds
These provide a fixed interest rate and can be redeemed after a year, but you will lose 3 months of interest if you hold them for less than 5 years. When you redeem the bond, you collect the amount you paid for the bond, plus the accrued interest. You can purchase them in the form of a paper certificate at a bank for half of their face value.
I Savings Bonds are similar to EE savings bonds, with the exception that they are indexed for inflation at 6-month intervals. These are always sold at face value, no matter if you buy paper bond certificates or electronically certificates.
Not quite as safe as Treasuries, but these are generally safer than the most pristine corporate bonds. They are issued by government-sponsored enterprises, as these are chartered companies and are regulated in part by the government. However, they are not backed by the “full faith and credit” of the US government like Treasuries.
Also commonly known as Munis, these are issued by cities, states, and local governments in order to be able to fund different projects. Municipals are not subject to federal taxes, and if you live where the bonds are issued, they might also be exempt from state taxes. Some municipal bonds are considered more credit-worthy than other municipalities. Some Munis are even insured, so if the issuer defaults, the insurance company covers the tab.
As you can see, bonds could be a viable investment tactic as they can provide both a stable income and security. With so many types of bonds to choose from, anyone could find something that would fit their particular financial situation.
Need more advice? Don’t hesitate to check out our complete guide to investing into stocks and bonds and learn how to anticipate market movements and navigate the trading field.