What Are Bonds and How Do They Work?
Most of us have borrowed money in our lives, whether it is to finance a college education or to ask the bank for a mortgage or auto lone. Now, just as people need money, so do companies and governments. Where do they get it? One option is to issue bonds, where thousands of investors each lend a portion of the capital needed.
In essence, a bond is nothing more than an IOU. The organization that offers the IOU (the bond) is known as the “issuer,” while the investor who purchases it is the “investor.” Because nobody loans his or her hard-earned money to an unknown party for nothing, the bond issuer is required to pay the investor interest payments, which are made at a predetermined rate and schedule.
Bonds are known as “fixed-income” securities because they provide a fixed amount of money if you hold on to them until “maturity.” If you purchase a bond that has a face value of $10,000, an interest rate of 8%, and a maturity of 10 years, you earn a total of $800 ($10,000 x 8%) in interest per year for the next 10 years. If your bond is like most and pays interest semi-annually, you receive two payments of $400 a year for 10 years. When the bond reaches maturity after a decade, your $10,000 is returned to you.
Bonds vs. Stocks
The important distinction between stocks and bonds is that bonds are “debt,” whereas stocks are “equity.” When you purchase stock, in effect you’re purchasing partial ownership of a corporation, which gives you certain rights, e.g. voting in shareholder meetings and sharing in corporate profits. On the other hand, when you purchase bonds you become a creditor to the corporation or government, which gives you a higher claim on assets than shareholders have. This means that, should the organization for which you hold bonds go bankrupt, as a bondholder you would get paid before a shareholder. The downside is that bondholders are only entitled to the principal plus interest and, as mentioned, don’t share in company profits. In sum, bonds come with less risk, but at a lower return rate.
Why Bother With Bonds?
Bonds tend to be the more logical option when you can’t afford the short-term volatility of the stock market. There are two scenarios when this is particularly true:
- Retirement: Retirees, who by definition live off fixed-incomes, can’t afford to lose their principal because they need it to pay their monthly bills. Therefore, bonds are the safe, logical choice.
- Shorter-term ROI needs: For this example let’s imagine that a young professional plans to return to graduate school in a few years’ time. While the stock market provides the opportunity for higher growth, the young professional can’t afford to lose the money for his/her education. Therefore a fixed-income security such as a bond is the wise choice.
To minimize risk, most personal financial advisors advocate diversifying your portfolio and changing its distribution of asset classes as you proceed through life. For example, in your 20s and 30s, your focus is on building wealth, so a majority of your assets should be in equities. In your 40s and 50s, as you begin to focus more on retirement, the percentages shift out of stocks and into bonds. In your 60s and beyond, the majority of your investments should be in the form of fixed income.
It is also worth mentioning that while bonds are generally safe bets, they aren’t risk free. It's always possible for the borrower to default on the debt payments. Government bonds are the safest bonds, followed by municipal bonds, and then corporate bonds. Bonds can be purchased through most banks and brokerages.
