If you are ready to diversify your investment portfolio, then you have likely heard about bonds. Bonds are especially useful if you are attempting to build a risk-averse portfolio.
Although bonds are far from risk-free, many people use bonds to balance out risky stock picks in their portfolio. Even if you only have a small percentage of bonds in your portfolio, you should still understand exactly what they are.
A bond is a loan between a borrower and a lender. As the investor, you would essentially buy an I.O.U. note from a borrower. The note will include the term of the loan, the payment schedule, and any other relevant details.
The bond boils down to a promise from the borrower to the lender to pay you back in full, plus interest.
Who issues bonds?
Any organization can issue bonds. The typical institutions that issue bonds are large companies, the federal government, cities, and states.
Many times the issuer of the bond will explain exactly why they need the money. The government may need it to build new roads or a company may need it to fund new research. The reason behind the issuance of bonds varies, but for one reason or another, the organization needs money.
Types of Bonds
There are several types of issuers that place bonds in different categories.
Any bond issued by the federal government is considered a government bond. Municipal bonds are issued by smaller government entities like a state or city. Finally, corporate bonds are issued by companies.
Government bonds have various types because the federal government has a variety of ways to issue bonds. Bonds that are issued specifically by the U.S. Treasury fall into the category of treasuries.
Any bond issued by the U.S. Treasury with a maturity date of one year or less is considered a bill. U.S. Treasury bonds issued with a maturity date between 1 and 10 years away is considered a note. Finally, the U.S. Treasury classifies any bond issued with a maturity date more than 10 years away is considered a bond.
Are all bond issuers the same?
No. It may be obvious, but some issuers are more trustworthy than others.
Generally, U.S. government bonds are considered the safest possible bond. Many deem these bonds as practically risk-free. Of course, there is always risk involved but it is rather unlikely that the U.S. government would default on its loan to you. Less trustworthy issuers are shady companies that you don’t trust.
A risky issuer will be forced to offer a higher interest rate than a stable issuer. That is because it is less likely that they will be able to repay the loan of the investor. If that happens, then the investor will lose their money. Bonds that offer higher interest rates are considered junk bonds. That is because it is likely that the issuer will be unable to repay their investor.
The U.S. government offers the lowest interest rate on their bonds. That is due to the fact that they are most likely to repay the investor. Stable private companies will fall somewhere in between. Bonds that offer lower interest rates are considered investment grade bonds.
How does a bond work?
When an organization needs money it will issue bonds with the terms already set. As an investor, you will need to either accept the terms or pass on the bond. The details of the bond will include the exact terms of the bond. Let’s take a look at what will be included in each bond offering.
- Issue price – The issue price is the price that the investor will have to pay for the bond.
- Face value – Typically, the face value of a bond is a nice whole number like $100 or $10000. It is unlikely that you would find a bond available for $99.47.
- Coupon rate – A coupon rate is equivalent to the interest rate that is on the bond. The issuer of the bond will pay this rate of interest to the investor.
- Coupon date(s) – Throughout the lifetime of the bond, the issuer may be required to make payments to the investor. The coupon dates will outline the amount of these payments and when they need to be made.
- Maturity date – A maturity date is basically the end of the bond. On this date, the issuer of the bond must pay the face value of the bond to the investor.
When you have all of the information, you will be able to make an informed decision about a bond purchase.
What impacts bond prices?
Many things go into the price of a bond, but these are the most common.
Issuer’s credibility. If a shady company is offering a high yield bond, then it will likely be classified as a junk bond. The risk will be reflected in the price of the bond.
Maturity date. The longer you have to commit your money to the bond, the higher the yield you will receive. The bond issuer is paying for the long-term use of your money.
Interest rates. Interest rates have the largest impact on bond prices. Higher interest rates will lead to lower bond prices.
Are bonds a risk-free investment?
No. Some bonds are significantly riskier than others. If a bond offers a high yield, then it is likely a risky investment.
Some people associate bonds with guaranteed returns. That is just not the case. You can lose money through bond investment. However, if you choose your bonds carefully, then this may be less of a worry. For example, if you choose to stick with U.S. Treasury bonds, then it is likely that your money will stay safe.
How does an investor make money with bonds?
When you purchase a bond, you can make money through a couple of ways.
First, you will receive interest payments on a regular basis based on the coupon rate of the bond.
Second, you can sell the bond for more than you paid for it. If interest rates go down, then bond prices will rise. At that point, you will have the option to sell your bond for a profit before maturity.
How to Invest in Bonds
You can get started investing in bonds with the following steps.
Step 1. Research your options. You do not want to just jump into a bond purchase. It is important to understand the terms of the bond before you purchase it.
Step 2. Buy the bonds. It is possible to buy bonds from multiple places. Your choices are either through a broker or directly from an issuer. If you want to avoid additional fees, then you may want to work directly with the issuer.
Investing in bonds is one way to diversify your portfolio.
Remember, bonds are not entirely risk-free. Do not assume that you will make money on a bond investment. It is entirely possible to lose money by investing in bonds.
Before you make any decisions about investing in bonds, research your options. It is important to understand all of the risks involved before you choose to invest your hard-earned money.