The Basics of Investing in Bonds

Bonds: A Clear Guide to Fixed-Income Investments

Entities such as companies, municipalities, and the federal government engage in borrowing practices when necessary, and they subsequently repay these loans with interest. This form of borrowing is referred to as a bond.

What Are Bonds?

Bonds are issued by governments and corporations seeking to raise capital. By purchasing a bond, you are providing the issuer with a loan; in return, they commit to repaying you the principal amount on a designated date, and they also agree to provide periodic interest payments throughout the bond’s duration. 

How Do Bonds Work?

A bond functions similarly to a loan you provide to another party. When companies, municipalities, or government entities need funds- they can issue bonds to investors prepared to lend them money instead of turning to a bank. Upon purchasing a bond, you are extending a loan to the issuer. In exchange for your investment, the issuer commits to paying you a specified interest rate, known as the coupon rate, while you maintain ownership of the bond. When the bond reaches its maturity date, the issuer is obligated to return the initial sum you lent (referred to as the principal or face value of the bond).

Why Do Investors Buy and Sell Bonds?

Investors buy bonds because:

• They provide a stable source of income through interest payments. This makes them appealing to people looking for consistent returns and income such as retirees.
• If bonds are carried to maturity, the entire principal amount will be returned to the bondholders. This makes bonds attractive for investors looking to protect their capital while earning some interest.
• Bonds are typically considered safer investments compared to stocks. There’s a lower risk of losing your funds if you invest in bonds from stable governments like the United States or well-established companies. This can help hedge exposure to more volatile stock holdings.

Risks Associated With Bonds

• Interest Rate Risk: Since bond prices have an inverse relationship with interest rates, bond prices will fall when interest rates go up and vice versa. For example, you would have to sell a bond at a lower price than you paid if you sell after interest rates have risen.
• Credit Risk: There is a possibility that a bond issuer will default if they are unable to make the interest payments or pay back the principal. Government bonds have lower risk while corporate and municipal bonds have more credit risk.
• Inflation Risk: If inflation rises, the fixed interest payments you receive may not be able to keep up with the increasing cost of living.

In a Nutshell

Bonds can be a crucial part of any investment strategy since they offer stability, income, and diversification. While they don’t have the upside potential of stocks, they can be a safer option to incorporate into your portfolio.