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Bonds are an important part of many investment strategies, and they come with risks and benefits that set them apart from other investment vehicles such stocks and real estate. Here are eight facts you should understand before investing in bonds.
1. Bonds Are Debt
Government entities and some companies issue bonds as a way to borrow money. When you buy bonds, you essentially become a lender. Each bond spells out terms of the loan, including how and when the loan must be repaid, and how much interest the borrower will pay. These terms can vary, so it's important to understand exactly the terms you're accepting when you purchase bonds.
2. Bonds Mature Over Time
All bonds have a specific maturation date—the day the bond issuer agrees to pay the bondholder the face value on the bond (also known as the bond's par value). Bonds can be issued with maturity periods of any length: Those that take 10 or more years to mature are considered long-term bonds; those with maturity dates between four and 10 years are medium-term; and those that mature in under four years are considered short-term.
3. Bonds Pay Interest
A bond's coupon is the amount of interest it pays annually. This interest is expressed as a percentage of the bond's par value. For example, a $1,000 bond with a coupon of 2% would pay $20 in interest each year throughout its maturity period. Zero-coupon bonds work a bit differently; they are sold at a discount relative to their par value, and you collect interest when you redeem them for full par value after they mature.
4. Bonds Have Multiple Values
When evaluating bonds, there are three interrelated monetary values to consider:
- The issue price is the amount it costs to buy the bond from the issuer the day it is first offered for sale.
- As discussed above, par value is the face value on the bond, and many bonds have par values in increments of $1,000. The minimum for many municipal-bond issues is $5,000, but U.S. Treasury bonds (or T-bonds) can have par values of $100. For most municipal and corporate stocks, issue price and par value are identical. The issue price on T-bonds is set using an auction process.
- Trading price refers to the stock's value when bought and sold in a secondary trading exchange, comparable to the marketplaces where stocks and commodities are traded. The trading price of any bond can fall above or below its par value, depending on prevailing interest rates and other market factors.
5. Bonds Come With Risk
Lending money always carries some risk that the borrower won't repay the debt, and when you buy bonds, you assume that risk. The likelihood a city, state or federal government will fail to pay its debts is typically considered slim (though municipalities have filed bankruptcy on rare occasion). Corporate bonds may be somewhat riskier, especially those known as "high-yield" bonds (or, more casually, as "junk bonds"), which can be difficult to trade on public exchanges.
Different bonds sold by the same issuer can carry different amounts of risk as well: For instance, a city may issue general-obligation bonds, which they promise to pay by any means necessary, or revenue-based bonds, which promise repayment using anticipated funds from income-generating projects such as toll bridges or airports. But if any of those projects fail to produce expected income, bondholders could lose out.
6. Bonds Have Credit Ratings
In much the way lenders use credit scores to evaluate your creditworthiness, you can use bond-quality ratings to help understand the risk associated with different bond issuers. Three major investment-rating firms—S&P Global Ratings, Moody's and Fitch Group—rate bond issuers according to the likelihood they will fail to repay a bond. Bonds from issuers with lower ratings typically pay higher interest rates as compensation to bondholders for assuming greater risk.
S&P and Fitch use identical rating scales, in which AAA is considered the best investment quality. They rank bond issuers with successively greater risk in groupings of AA+, AA, AA-, A+, A, A-, BBB+, BBB and BBB-. Their scales extend to ratings as low as D, but bonds with ratings below BBB- are considered less than investment quality. Moody's uses an analogous scale that rates top-quality bond issuers Aaa and ranks issuers in order of successively greater risk as Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2 and Baa3. The Moody's scale ends at C, but issuers rated below Baa3 are not considered investment-grade.
7. Some Bonds Can Retire Before Maturity
Some corporate bonds are callable, which means the issuer has the option of repaying their par value ahead of the maturity date. These bonds typically pay higher interest rates than those that are not callable, but they carry the risk that their total interest yield will be cut short if the bond is retired early.
8. Bonds Are Generally Considered Safe Investments
No investment is risk-free, but bonds are typically seen as relatively safe investments, particularly in contrast to stocks. To the extent the federal government, most municipalities and many bond-issuing corporations are viewed as stable and trustworthy, the returns on their bonds are highly predictable. For example, you can easily calculate the total yield on a bond on its issue date and hold until maturity.
Buying and selling bonds over the course of their maturity periods can complicate matters, but the bond market overall is less volatile than the stock market. Bonds' stability and fixed interest rates—the qualities that make them predictable—also mean they typically have far lower growth potential than individual stocks. For this reason, retirement planning experts often build lifetime-investment strategies around a combination of stocks and bonds.
The Bottom Line
Depending on your age, income and other assets, you might dedicate a higher portion of savings toward stocks early in your working life, and then shift toward more predictable bond holdings as retirement age approaches.