Bonds
By definition: A debt investment in which an
investor loans money to an entity (corporate or governmental) that borrows the
funds for a defined period of time at a fixed interest rate.
What this means…
A bond is a loan. It's that simple. Instead of you borrowing money from
a bank, a company or government is borrowing money from you.
How do bonds work?
Bonds are an important part of an investor's portfolio, typically
providing low but relatively stable returns. A bond can be considered a type of
"loan". When a government or a corporation needs money, they can
either borrow it from the bank, or they can borrow it from willing investors.
When borrowing from investors the company will issue a bond in exchange for the
money. The amount of money that is borrowed is called the "face
value" or the "principal". The bond will promise the investor
periodic interest payments (or coupon payments) over a certain time period.
Most bonds are considered "fixed income securities" because the
coupon payments are a fixed amount. Bonds typically pay these coupon payments
annually, semi-annually or quarterly. At the end of the time period (called the
maturity date), the investor is paid back the amount that was borrowed (the
principal).
What about the Federal Reserve and interest rates?
Like stocks, bonds can be traded in a secondary market. In the secondary
market, bonds will have a "price" that is often higher or lower that
the principal amount. A major factor that affects the price of a bond is the
market interest rate. The US Federal Reserve has a big influence over the
market interest rate in the US. When market interest rates rise, the price of
the bond falls, and vice versa. However, this only affects investors that
actively trade bonds. On the other hand, investors that hold onto bonds until
the maturity date are promised the principal amount, and aren't affected by the
price of the bond. Unless a company goes bankrupt, no matter what happens with
interest rates, an investor will receive that principal amount at the maturity
date.
Why do people invest in bonds?
People invest in bonds because they are less risky than stocks, and
still provides a relatively stable return. Keep in mind, while stock returns tend to
outpace inflation, bond returns are eroded by inflation. Because the coupon
payments of the bond tend to be fixed, the payments lose purchasing power as
prices rise due to inflation. However, the advantage of bond returns is that
they are less risky than stock returns. A company must make their debt
payments, before they can declare a profit. Additionally, government bonds are
generally considered safer than corporate bonds, since governments are less
likely to default on their payments. Hence the coupon payments on your bonds
are generally more secure than your stock returns.
