Even if you are fairly unfamiliar with investments you may have heard the word “bonds” thrown around before. Perhaps in the context of a statement like “I am in a portfolio with 60% stocks and 40% bonds.” In this post I will explain what bonds are as well as talk about a few of the different varieties of bonds that exist in the market.
What Are Bonds?
Bonds are an investment vehicle through which you lend money to an entity (most of the time a corporation or a government) and in return you receive interest payments, much like those that you may have paid on your own debt, except that with bonds, the entire principal is usually returned when the bond matures.
Bonds are generally considered to be a safer investment than stocks due to the fact that you are guaranteed a positive return if you hold the bond until maturity as long as the issuer does not go bankrupt and default on the debt. Also, when a company goes bankrupt, owners of the stock almost always end up with $0 where as the creditors (bond owners and other people who lent money to the company) get first dibs on whatever can be salvaged.
Okay, I just used a bit of jargon there so lets define a few terms before we go further:
Principal: Also known as “face value” or “par value” this is the amount that the original bond buyer is effectively loaning to the entity. That’s right, you’re pretty much acting like a bank.
Maturity Date: This is the date on which principal is returned to the investor and interest payments cease.
Yield: Also called “coupon rate”, a bond’s yield is the sum of its annual coupon payments divided by its par value. If our $5000 bond pays $250 worth of coupon payments over the course of a year it is said to have a 5% yield.
Types Of Bonds
When it comes to bonds one of the most important considerations (and how they are categorized) is who is issuing them. In other words, who are you lending money to if you buy a certain bond.
Treasury bonds are bonds issued by the U.S. Treasury and are generally considered to be the safest type of bond investment. If you ever hear someone on the news talking about “10 year yields” rising or falling, they are referring to the yields of 10 year U.S. Treasury bonds.
Investment Grade Corporate Bonds
Corporate bonds typically have higher yields than treasury bonds. Yield corresponds with a company’s credit rating. Investment grade bonds are those with a rating of BBB- or higher. For a more in-depth understanding of company credit ratings check out this Wikipedia article.
As the name suggests, high-yield bonds typically have higher yields. With higher yields come higher investment risks. Companies issuing high yield bonds typically have weaker balance sheets and are more likely to default, causing investors to lose their money. These companies have credit ratings below BBB-.
Municipal bonds or “muni bonds” are issued by U.S. states and local governments. These bond issues are commonly sought after due to the fact that most of them offer interest payments that are tax-exempt. States and local governments are also subject to credit ratings should they decide to issue bonds. Due to their tax benefits, municipal bonds will typically have lower yields than corporate bonds with their same credit rating.
When To Buy Bonds
Whether you want steady, reliable payments or just don’t want the same downside risk that stocks carry bonds may be right for you. Typically the closer people get to retirement, the larger the portion of their portfolio that they allocate to bonds for both the income and safety aspects. Keep in mind, while bonds are safer than stocks you should always do your research and know that if you are purchasing higher yield bonds they come with a greater default risk.
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