Bonds can be common components of many diversified portfolios. While they are popular with conservative investors, they may also appeal to more aggressive investors.
Among other things, bonds can help reduce the effects of stock market swings on a portfolio while providing income. But like any investment, they can also lose money.
What Is a Bond?
When you buy a bond, you lend money to the bond issuer. This could be a business, a government body, or another organization. The loan lasts for a set period of time. In return, the issuer promises to repay the loan either in regular payments during the term or in full at the end.
A bond can be bought or sold in global financial markets. Its market value can change based on demand and economic conditions.
Individual Bonds
Bonds can be bought one at a time. With individual bonds, you can choose specific issuers and interest rates. You can also select bonds with repayment dates that match your needs. You can hold the bond until it matures or sell it in the secondary market. If you hold it to maturity and the issuer repays the loan, you should receive the full amount promised, even if the market price changed over time.
Multiple Bonds
Bond mutual funds invest in many bonds at once. A mutual fund may hold hundreds or even thousands of bonds from different issuers with different maturity dates. Prices change daily as the value of the holdings rises or falls. There is no guarantee of a set rate of return.
How Do Bonds Work?
Bonds pay interest on the money you lend. The issuer sets the interest rate based on economic conditions and its credit rating.
Interest Rates
Interest rates in the broader economy affect many things, from savings accounts to mortgages. When rates rise, interest rates on newly issued bonds often rise as well. At the same time, existing bond prices tend to fall.
Most bonds keep the same interest rate after they are issued. This means market rates may move higher or lower than the rate on your bond.
Bond Ratings
Bond rating agencies help investors measure risk. A strong issuer may receive a "AAA" rating, while a higher-risk issuer may receive a "C" rating. In general, higher-rated bonds offer lower interest rates. Lower-rated bonds usually pay higher rates to make up for added risk.
Financially strong issuers can borrow at lower rates because investors expect them to make payments as promised. Still, a high rating does not guarantee repayment.
Types of Bonds
Government Bonds
Countries around the world issue bonds. Bonds backed by the U.S. government often receive high ratings. U.S. savings bonds are considered very stable, but they can still be affected by interest rate changes. Bonds from other countries may involve political or currency risks.
Investment-Grade Corporate Bonds
Companies issue bonds to raise money. These bonds often pay more than U.S. government bonds but do not have government backing. If a company struggles, payments could be at risk.
High-Yield Bonds
Also called junk bonds, these pay higher interest rates because the issuers have a greater chance of default. They are rated below BB/Ba and are not considered investment grade.
Municipal Bonds
States, cities, and local governments issue these bonds to fund projects and services. The income may be exempt from certain taxes. It may help to check with a tax professional before investing.
How Are Bonds Different From Stocks?
Bonds and stocks represent different ways to invest:
- Bonds: You lend money to an issuer that agrees to repay you with interest.
- Stocks: You buy ownership in a company, and the value can rise or fall based on market performance.
Bonds can be less volatile than stocks, but they still carry risk. If the issuer defaults, you may not receive interest payments or your principal.
Bondholders are paid before stockholders if a company goes bankrupt, though repayment is not guaranteed. Bonds also do not benefit directly from a company’s growth, so their return potential is usually lower than stocks.
Interest-Rate Risk
Bonds are affected by changes in interest rates. For example:
- When interest rates rise, bond prices typically fall.
- When interest rates fall, bond prices may increase.
Most bonds pay a fixed interest rate. This means the interest payments stay the same, even if newer bonds offer higher rates.
Example
| Scenario | Interest Rate | Annual Payment |
|---|---|---|
| Original bond | 3% | $300 |
| New bonds issued later | 4% | $400 |
If you try to sell your 3% bond after rates rise, buyers may only be willing to pay less for it since newer bonds offer higher returns.
If you hold a bond until maturity, price changes may matter less because you continue receiving the agreed payments.
Final Thoughts
Bonds can provide income and help reduce the impact of market swings. It is important to understand the risks. Rising interest rates can lower bond prices, and there is always a chance that an issuer may fail to repay its debt.
Footnotes
- Provided for informational purposes only. Not all products and services discussed are available through member of Western & Southern Financial Group.
