Financial Literacy - Financial Tuneup
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investing
Building blocks for successful investing

Bonds

Whereas equities represent ownership in corporations; bonds represent loans made by investors to the issuer. Corporations, municipalities and the government issue bonds to raise money.

"You're loaning money to an entity; it could be the government or a corporation. And they agree to pay you interest and then pay you back your principal at the end of the term," says Kinder.

The issuer repays the original investment after a stated amount of time, known as the term to maturity. Bonds mature at varying times; between five years and 30 years are the most common. Longer term bonds produce higher yields. "The longer the maturity, the more that investors demand in return," says Kinder.

While maturities influence the yield or the interest rate that investors receive on bonds, quality also matters. The highest rated bonds are from the Treasury because they are virtually risk-free. "The higher the quality, the lower the interest they're going to pay you, because of the higher guarantee you'll get your money back," says Kinder.

For those who like to live dangerously, junk bonds (also called high-yield bonds) generally offer the highest yields -- as well as a higher probability that the company will default on its loans. However, most advisers recommend bonds as a conservative anchor in an investment strategy and some like to just stick to the basics.

"In the bond market, it's not like you can make a huge return, so why not go with some type of Treasury where you have a guarantee of the full faith and credit of the U.S. government behind the bond and receive income that has historically been between 4 (percent) and 6 percent and be very safe," says Flower. "It really acts as stability for an overall portfolio."

The value of the bond can also fluctuate throughout the term, but that only affects bondholders if they sell their bonds prematurely. "If interest rates increase, the bond that you hold is probably going to be worth less because people know that they can go out and get a bond that pays a better interest rate -- and if rates go down, your bond now has a higher interest rate than other ones out there and it becomes a bigger value," says Flower. "But you're always receiving that income from the interest rate attached to that bond."

Advantages and disadvantages of bonds
Pros
  • Bonds can be very low-risk and offer a fixed rate of return. In a balanced portfolio, bonds provide a buffer of constant yields when the stock market falters.
  • "The returns on bonds will not move in the same direction as the returns on stocks," says Brosious. "So that tends to smooth out your portfolio earnings. One year you might have bonds gaining 5 percent and stocks maybe losing 10 percent. The next year you might have stocks gaining 15 percent and bonds being a little flat."
  • In general, bonds offer less return for less volatility, says Kinder.

Con
  • The dreaded "I" word: inflation. Because they offer a fixed return, the cost of goods and services could rise beyond what the interest will buy in the future. "If you have spikes in inflation, the interest you're earning off of bonds won't buy as much as it did before," says Kinder. One type of fixed income investment, Treasury Inflation-Protected Securities, or TIPS, can temper the effect of rising inflation, similar to the I bond.

 

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