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Bonds
Generally, many investors consider bonds when they want to invest conservatively. Unlike equities or stocks, the steady stream of income that bonds can provide may have a stabilizing effect on your overall portfolio during periods of stock market volatility. Since bond performance does not tend to move in tandem with equities, this asset class may be an excellent choice for diversifying your portfolio.
What are bonds?
Bonds are, in essence, loans that investors make to corporations and government entities. When you purchase a bond, the issuing company promises to pay you a stated amount (the "face amount" or "par value") at the bond's maturity. Generally (but not always) you also receive a promise to be paid a fixed amount of interest at set intervals (the "coupon rate").
Types of Bonds
Bonds are issued by the U.S. government, government-sponsored entities, municipalities, and corporations. The primary differences among these bonds relate to credit risk and taxability.
U. S. Treasuries: Issued and backed by the full faith and credit of the federal government. Considered among the safest bonds. Usually issued for 10 and 30 years. Interest is exempt from state and local taxes.
Agencies: Issued by governments-sponsored entities ("GSEs"), such as Fannie Mae and Freddie Mac and backed by the full faith and credit of the federal government. Depending on the GSE, the interest may be exempt from state and local taxes.
Municipals: Issued by states, cities, counties and towns, usually to finance specific projects. Depending on your place of residence and the issuer, interest may be exempt from federal, state and local taxes.
Corporates: Issued by public companies for different corporate purposes, including expansion or acquisition. These bonds may be secured against specific assets or unsecured, and may be rated as investment grade or non-investment grade, reflecting the credit risk. Interest payments are fully taxable.
Mortgage-backed: Banks and other lending institutions pool mortgages and offer them to investors. Interest payments are fully taxable.
About Bonds
While bonds are generally thought of as a more "stable" investment than stocks, there is, of course, still a certain amount of risk. Here are some important things to keep in mind when you are planning to invest in bonds:
- Individual bonds usually pay interest semiannually based on the bond's coupon rate, and your principal is repaid at maturity.
- It's important to keep risk preferences in mind when selecting individual bonds for your portfolio. Lower-rated, non-investment-grade bonds are considered more aggressive and riskier than bonds of higher quality. Likewise, bonds of longer maturity generally involve more risk than bonds of shorter maturity.
- Investing in individual bonds involves interest rate risk. If interest rates rise after you purchase the bond and you decide to sell before the bond's maturity, you may suffer a loss of principal.
- Individual bonds are also subject to credit risk. For example, the issuer may default on an interest payment or the principal amount of the bond at maturity.
- All bonds will fluctuate in value during the life of the bond.
Also, before you invest in bonds consider the following:
- The Financial Health Of The Issuer: The risk that the issuer may default on the interest or principal affects the price of the bond. Bonds issued by entities with a higher risk of default will have a higher coupon rate or will sell at a discount to face value.
- Coupon Rate, Price and Yield: Most bonds have a stated coupon rate indicating the rate of interest that will be paid. The price you pay for the bond will affect the yield on your investment if you hold the bond to maturity.
- Consequences of Rising Interest Rates: Rising interest rates will typically cause an outstanding bond to decrease in value.
- Tax Consequences: Depending on your tax bracket and the jurisdiction in which you live, it may make sense for you to compare returns between taxable and non-taxable bonds.
- Bond Market Transparency: It is generally more difficult to determine the exact price for a bond than for common stock. Bonds traded in the secondary market fluctuate in response to changes in interest rates. It is often helpful to review yield curves for indices of comparably rated securities and Treasuries.
For additional information, please see:
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