Bonds are a common investment.
However, to many investors,
they remain a mystery.
So let's explore what a bond
is and how it might benefit
your investment portfolio.
A bond is simply a loan given
to a company or government
by an investor.
By issuing a bond, a
company or government
borrows money from investors,
who in return are paid interest
on the money they've loaned.
Companies and governments
issue bonds frequently
to fund new projects
or ongoing expenses.
Some investors
use bonds in hopes
of preserving the money they
have while also generating
additional income.
Bonds are often viewed as a less
risky alternative to stocks,
and are sometimes used
to diversify a portfolio.
Consider this example.
The city of Fairview wants to
build a new baseball stadium,
so it decides to issue
bonds to raise money.
Each bond is a loan for
$1,000, which Fairview promises
to pay back in 10 years.
To make this loan more
attractive to investors,
Fairview agrees to
pay an annual interest
rate of 5%, which
in the bond world
is also known as a coupon rate.
An investor buys the bond
at face value for $1,000.
Now, let's fast forward.
Each year the city of Fairview
pays the investor $50.
These regular interest rates
continue for the length
of the bond, which is 10 years.
Once the bond reaches maturity,
the investor redeems his bond,
and Fairview returns his
$1,000 principal investment.
This bond was a good deal for
both the city and our investor.
Fairview got the money it
needed to build the stadium.
The investor received
regular interest payments
and the return of the
original investment.
Because a bond offers
regularly scheduled payments
and the return of
invested principal,
bonds are often viewed as a
more predictable and stable form
of investing.
Compare regular
payments of a bond
to the experience
of owning a stock.
With stocks, profits and losses
are driven by market forces
and are generally
less predictable.
Of course, like any investment,
bonds are not without risk.
One risk that bond
investors face
is the possibility that
the issuer defaults
on paying back the principal.
This is what is known
as default risk.
Typically, bonds with
higher default risk
also come with
higher coupon rates.
The amount of risk
depends mostly
on the financial
stability of the issuer.
For example, most
governments are generally
considered stable
issuers and issue bonds
with a relatively
low coupon rate.
Corporate bonds typically
represent a greater risk
of default, as companies
can and do go bankrupt.
That's why corporate bonds often
offer a higher coupon rate.
Several credit rating
agencies assign rankings
to different bonds.
This can help bond investors
to gauge the financial strength
of the bond issuer.
These ratings agencies
often use different criteria
for measuring risk.
So it's a good idea to
compare ratings when
considering a particular bond.
And keep in mind,
rating agencies
aren't always accurate.
So be sure to research
a bond and its risks
thoroughly before investing.
Another risk to consider
as interest rate risk.
This is the risk that
interest rates will go up
and any bonds you own
will be worth less if sold
before the maturity date.
After all, when
interest rates rise,
more investors
allocate their money
into the new, higher
interest rate bonds.
If you wanted to unload
a low interest rate
bond to take advantage
of these new rates,
you would have to sell
your bond at a discount
to make it a worthwhile
purchase for another investor.
Capital preservation
and income generation
are just two ways
bonds might be part
of a diversified portfolio.
Many investors use a
mix of stocks and bonds
to pursue their
investment goals.
And because bonds moved
differently from stocks,
they can help increase or
protect portfolio returns.
Keep in mind that this
discussion showed you
one simplified
way that investors
might use bonds and only a
few of the risks to consider.
Like all investments,
bonds are complex
and have a variety
of uses and risks.
Before you invest in
bonds, it's important
that you invest in your
own financial education.
