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An Introduction to Bonds

An Introduction to Bonds

If you’re newly looking to get involved in investing, you’ve no doubt heard of bonds; they’re one of the most common—and simplest—options. Bonds are a relatively safe, low-yield investment vehicle, considered safer than buying and selling stocks. In the world of investment, it’s typical for risk and potential reward to be proportional.

So what exactly are bonds? They’re loans made by an investor to a borrowing institution—usually a government body or corporation. When you buy a bond, you’re lending that money to the borrower, who agrees to pay you back with interest in a predetermined amount of time.

Because of their predictability and relative safety, most investors find it appealing to include some bonds as part of a diverse portfolio. Although the return doesn’t match the potential of stocks, they can help mitigate loss from poorly performing stocks or other riskier investment vehicles.

Here’s an introduction to bonds to help answer the basic questions new investors usually have.

Key Features of Bonds

  • Generally, interest payments are made to the investor annually or semiannually, and the point at which the principal is due is called the maturity date; some bonds (known as zero-coupon bonds) are paid out in full—principal and interest—all at once at the maturity dateMaturity dates typically fall within 1 to 30 years; generally, the longer the term, the greater the yield
  • The primary risk involved with bonds is that the borrower defaults on the debt obligation
  • US government bonds (known as Treasury bonds or T-bonds) are considered the safest, backed by the nation’s “full faith and credit;” municipal bonds from state, city, or county governments are considered the next safest, followed by corporate bonds
  • A bond’s interest rate is largely determined by the creditworthiness of the borrower (in other words, the safer the bond, the lower the yield)
  • Bonds don’t offer much in the way of liquidity; they can be sold on the secondary market before their maturity date, but this is often difficult and likely to result in a loss
  • As a fixed-rate interest-bearing security, bonds lose value when interest rates rise; newer bonds with higher interest rates are better investments than older ones with fixed lower rates, hurting the older ones’ resale value
  • There are variable rate bonds as well
  • Investors can buy into bond funds that pool multiple bonds to promote diversity (often structured as a mutual fund); these can provide greater returns, but also have higher risk because prices and interest rates aren’t fixed
  • The older the investor, the more appealing bonds may be because of their stability; stocks often require riding out fluctuations in the market over the long term, so are often considered better suited to younger investors

Interested in Investing in Bonds?

Bonds are generally considered a smart inclusion in any well-diversified investment portfolio. However, the return is low enough to prevent them from being a significant wealth-building tool. Finding the right balance among the many types of investment vehicles for your monetary circumstances and goals is essential. Consult your professional financial adviser for help in determining whether bonds are a smart pick for your portfolio, and exactly how much they should figure in.

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