Back to Basics with Bonds
Today we’re going to go back to basics and uncover some of the main features and objectives of bonds!
What is a bond?
Bonds are considered one of the three main asset classes (the others are equity and cash equivalents). Bonds are used to raise money. Cities and towns can use bonds to build schools, roads, other buildings, etc. for the benefit of the people in that municipality. Bonds can also be used by governments and corporations to raise money – the original GoFundMe.
A bond is a loan made to a borrower from a lender. Bonds are tradeable on the stock market so if you were to purchase a bond, in this case you would be considered the lender. Bonds are sensitive to interest rates and they move in the opposite direction. For example, if we’re seeing interest rates decrease, the price of bonds are going to increase.
How would an investor make money on a bond?
While the borrower has your money and is using it to build schools, roads, or for other capital expenditures, the lender should get compensated for that, right? Bonds generally pay a fixed amount of money (called a coupon) in the form of an interest rate to the lender in return for being able to use their money. When the borrower is done, the bond matures (expires) and the lender gets paid back the original value of the bond.
Why would an investor purchase a bond?
In addition to the coupon mentioned above that provides a fixed income stream, the investor is guaranteed to get their original money back if they hold the bond to maturity. Since there a certain level of safety and guarantee here, bonds can help mitigate volatility in a portfolio.
What are some things to look out for?
Check out the volatility of the bond - if the coupon is super high, the investor is going to take on more risk when they buy that bond (keep your eyes peeled for an upcoming Money Monday video about risk vs. return).
Research before you buy! Check out the company or municipality and its financials. Just because bonds tend to be lower in risk than equity, doesn’t mean they’re risk FREE. It’s important to do your homework on the company’s financials, credit rating and history.
Lastly, bonds are not for everyone and may fit differently into investment portfolios. It’s important to talk to a qualified financial professional prior to investing in bonds. I’m happy to discuss this further with you – fill out the contact form at the bottom of the page for a complimentary consultation.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.