Bonds might not have the glitzy appeal of blue-chip stocks or compounding-interest mutual funds, but they remain a favorite investment instrument for the majority of financial wizards. If you’ve never considered purchasing a bond, though, you may not see the inherent value in it.
Compared to stocks and mutual funds, bonds are some of the safest, most stable investments you can make. A bond is essentially an IOU issued by entities such as the government or a global corporation that remains steady even through turbulent economic times. Even when stocks are in free fall, bonds tend to increase in value, helping to offset your losses.
In this post, we’ll explain everything you need to know about investing in bonds. Although they usually generate smaller returns, bonds are an excellent and wise investment for any portfolio. Let’s take a look at how they work and how you can add bonds to your list of financial assets.
What is a Bond?
A bond is a debt security in which an investor loans money to an entity for a defined period of time. The entity, also known as the issuer, agrees to pay the investor a set rate of interest (coupon) over the life of the bond and to repay the principal, also known as the face value or par value, when the bond matures.
Bonds are issued by national governments, municipalities, corporations, and other entities to finance a variety of projects and activities. The term of a bond can range from a few months to 30 years. The coupon rate is the interest rate paid by the issuer on the bond’s face value. It remains fixed throughout the life of the bond.
The maturity date is the date on which the bond expires, and the issuer must repay the face value to the investor. Bonds can be classified into two broad categories:
- Debt securities that are backed by the economy of the issuing government. These are known as government bonds or treasuries.
- Debt securities that are not backed by the full faith and credit of the issuing government. These are known as corporate bonds.
Government bonds are considered to be the safest option because the issuing government can tax its citizens to repay the debt. Corporate bonds are considered to be riskier because there is no guarantee that the issuing company will be able to repay the debt.
Why Invest in Bonds?
Although they are often less publicized, most professional investors have a selection of bonds in their portfolios. This is for a number of reasons, including:
- Safety – Bonds are considered to be one of the safest investments because they are protected by the economy of the issuing government.
- Stability – The coupon rate on a bond remains fixed throughout the life of the bond. This means that your investment will not fluctuate in value like it would if it were invested in a stock or mutual fund.
- Diversification – Adding bonds to your investment portfolio will help to diversify your assets and reduce your overall risk.
- Income – The interest payments you receive from investing in bonds can provide you with a source of income, especially if you’ve invested a substantial amount into bonds.
- Tax benefits – The interest you earn on a bond is often exempt from state and local taxes.
- Long-term investment – Bonds are long-term investments. This means that you can hold on to them for years and receive a steady passive income stream.
Currently, the set interest rate for U.S. government bonds is set at 9.62%. This is quite a bit lower than what you’d earn from a mutual fund or an individual stock investment but the stability and guaranteed payout from a bond make it a more attractive fallback for many investors.
How to Purchase Bonds
There are a few ways to purchase bonds—from the issuing government/municipality or through a broker. The process is relatively simple and can be done online. When you purchase a bond, you’ll need to pay the face value of the bond, known as the principal. For example, if you purchase a $1,000 bond, you must deposit an upfront payment of $1,000 to the issuing entity.
As the bond matures, the issuer will then pay interest payments until the bond matures. At the date of maturity, the issuer will then repay the face value of the bond. It’s important to note that bonds can be bought and sold before they mature, though. If you need to sell before the maturity date, you may receive more or less than the face value, depending on market conditions.
The Bottom Line
Bonds are a safe, stable investment that can provide you with a steady source of income. Although they may not have the same earning potential as stocks or mutual funds, bonds can help to diversify your investment portfolio and reduce your overall risk. Purchase bonds today and grow your assets year by year.