Experienced investors know to keep a healthy proportion of their investments in low-risk products. This way, no matter what the market does, some of your money is safe. Some of the best-known stable investments are bonds.
With low risk, stable gains, and endless possibilities, bonds form a solid base for your investment pyramid.
What Are Bonds?
In simple terms, a bond is an investment that represents a loan you give to another party (a company, a government, etc.). The other party, which borrows the money, is called the issuer. They repay you according to set terms, including interest. Usually the interest (that is, the dividends you receive) remains fixed. During the time you hold the bond, you receive coupon payments, which are the interest payments on the loan. On the maturity date, the issuer pays back the entire face value of the bond.
The face value of a bond is normally set at $1000. This might not be the amount you pay, but it’s the amount the issuer must repay at the maturity date. The amount you actually pay is called the issue price, and it depends on market rates. You do not have to hold the bond until its maturity date. You can resell it to another party, or the issuer can offer to purchase it back to get a better deal as interest rates change.
Types of Bonds
Bonds can be categorized by who issues them or by their features.
- Corporate bonds: These are bonds issued by a company to raise capital. Since bond obligations must be paid before stockholders in the event of the company going under, they’re a safer bet than stocks.
- Municipal bonds: Often a city or state issues bonds to raise capital for important expenditures, like a new bridge or a road improvement.
- Treasury bonds: The US government’s bonds are extremely secure, though also low-yield, investments.
- Agency bonds: These bonds are issued by governmental agencies like Fannie Mae and Freddie Mac.
- High yield bonds, also known as junk bonds: These are issued by higher-risk corporations. With the higher chance of default, your yield will be higher.
- Zero-coupon bonds: These do not pay coupon payments (interest) so your final profit may be higher at maturity.
- Convertible bonds: These are corporate bonds which you can exchange at a later date for stocks if the company does well.
- Callable bonds: The issuer can call these bonds back before the maturity date—forcing you to sell them back—if they think they can get a better interest rate. The risk for these bonds is higher.
- Puttable bonds: In contrast, you can sell these bonds back to the issuer later if you are worried the bond will fall in value. It reduces your risk.
Investing in Bonds
If you’re considering investing in bonds, you have almost endless options. You’ll need to assess the bonds available to you by various traits.
First, consider their yield. The coupon yield is the amount of interest you will make annually. For instance, a 5% coupon yield, on a $1000 bond, will give you $50 each year till maturity. However, the actual profit you’ll make is better seen in the bond yield, which includes the profit you make if you buy the bond for below its face value. For instance, if you buy that $1000 bond for $900, you’ll receive both $50 a year and $100 of profit when the bond matures and you receive the full face value back.
If you’re considering buying or selling bonds on the secondary market, you’ll need to know the market price. In general, when interest rates go up, the market price of your bonds will fall. Investors would rather buy a new bond at the new interest rate than buy the one you’re holding. But when interest rates go down, bonds on the secondary market (at the higher interest rates of the past) look more attractive and will be valued more highly.
Next, consider the financial stability of the issuer. The US government is very stable, but corporate issuers and even municipal governments will sometimes default. These bonds should offer higher interest to sweeten the deal for potential buyers.
Last, consider the time horizon. You probably won’t be holding your bonds till maturity, but the time to maturity still matters. Investors who might buy the bond will worry inflation will devalue the investment in the time before maturity. Thus longer-maturity bonds will also have higher interest rates.
Get Expert Help With Your Investments
If you’re investing in individual bonds, you shouldn’t be flying solo. Discuss your portfolio strategy with an expert advisor who has a fiduciary duty to work toward your benefit. We can connect you with the right advisor for you, beginning with a simple phone call.