Plain English Investing in Bite-Size Pieces: What the Heck are Bonds?

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If you plan to invest for longer-term goals, such as college or retirement, you need more than what a savings account can offer.  Perhaps you are considering purchasing stocks or bonds?   You can read about how stocks work here.  But what are bonds, and are they right for you?

Bonds are issued by companies and governments.  When a company or government needs money to fund operations, they ask for a loan in the form of a bond.  A bond, then, is just what it sounds like: It’s a promise to pay back the money borrowed within some designated time – along with interest.

A company may be planning to expand their offerings or operations, or a governmental entity may decide to build roads or schools, for example.  By issuing bonds, the company or government can borrow from more than one lender to accomplish their goal.

Investors in bonds benefit from the interest that the bond pays.  Some investors buy bonds and simply hold them to their maturity date.  At the maturity date bond investors receive the principal (the amount they “loaned” to the company) back in full.  Seems easy and straightforward, and in theory it is.

But there are risks to bonds, just like there are with stocks.  With stocks, if the company goes bust, the value of your shares can go to zero.  With bonds, there are some protections if the company has difficulty, but you still could conceivably lose your principal and/or interest payments.  The more frequent and common risk of investing in bonds is the need to liquidate the bond – perhaps because you need money for something else – before its maturity.  In that case, you face interest rate risk.

When the economy is doing well, interest rates tend to go up.  When interest rates go up, the value of bonds tends to go down.  Here is an example.  Let’s say that five years ago, you bought a company’s bond that was paying 4% interest annually.  Maybe that was a very competitive and attractive interest rate at that time.  If the economy heats up and interest rates rise, companies may now be issuing bonds that are paying 6%.

Logically, you may decide, “Hey, I’d really prefer to be making 6% than my measly 4%!”  So, you attempt to sell your bond in the bond market.  But guess what?  Why would I, as another investor, be interested in buying your bond, when I can buy a brand-spanking new bond with better interest?  If you want to sell your bond, you will have to sell it at a discount, which cuts into the overall earnings you made on the bond.

In a similar fashion, if the economy slowed down and interest rates went down, new bonds might be issued for 3%.  Then your bond would sell at a premium, because other investors would prefer to have your higher-paying bond.

Just like with stocks, it can be risky to put all your money into a single bond.  The use of mutual funds or exchange-traded funds (ETFs) can help smaller investors diversify their investments to reduce the risk.  Another risk you may face with bonds is default risk.  Some companies (or governments) are just plain riskier than others.  Typically, companies with higher risk have to pay higher interest payments than less risky companies.

Here’s a fact about all investing: If you want to achieve higher returns, you must take more risk.  Therefore, paying close attention to the risks present and the rewards offered is critical to successful investing.

This is just a basic introduction to bonds.  I promised bite-size pieces but if you want to learn more, there’s plenty to explore about bonds.  If you’re interested in a particular type of bond or have specific bond questions, let me know.  You’ll have the opportunity below to request additional installments in the exciting saga of “The Life and Times of Bonds.”  Ha!

As a rule, bonds are dull so it’s unlikely you have fun, exciting, riveting stories about bond investing.  But I’d love to hear stories about your experiences as an investor in general.  Got any stories or tips to share?

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