Most of us have borrowed money in our lives, be it to finance our college education or to ask the bank for a mortgage or auto loan. So just as people need money, so do companies and governments. One option for this money is to issue bonds in which thousands of investors each lend a portion of the capital needed.
What Is a Bond?
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 purchaser is the “investor.” Because nobody would loan 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. Let’s say you purchase a bond that has a face value of $10,000, an interest rate of 8 percent, and a maturity of 10 years. You would earn a total of $800 ($10,000 x 8 percent) of interest per year for the next 10 years. If your bond is like most and pays interest semiannually, you’d receive two payments of $400 a year for 10 years. When the bond reaches maturity after a decade, you would get your $10,000 back. Bonds can be purchased through most banks and brokerages.
Bonds vs. Stocks
The important distinction between stocks and bonds is that bonds are debt and stocks are equity. When you purchase stock you’re in effect purchasing partial ownership of a corporation, which gives you certain rights such as voting in shareholder meetings and sharing in corporate profits. But 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 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 also a lower return rate.
Why Bother with Bonds?
Bonds tend to be the more logical option whenever you can’t afford the short-term volatility of the stock market. There are two scenarios when this is particularly true: retirement and shorter-term return on investment needs. Retirees, who by definition live on 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. For shorter-term ROI needs, let’s imagine a young professional who is planning 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 the risk of losing the money for his or her education. Therefore a fixed-income security such as bonds 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 when your focus is on building wealth, 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 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.