Bonds: An Introduction
One of the most important reasons why investors choose bonds is for their steady and predictable stream of income through interest payments. Bonds have traditionally been important for retirees for this reason.
What are bonds?
Bonds, sometimes called debt instruments or fixed-income securities, are essentially loans. Corporations often raise money by issuing bonds in addition to selling stock. Governments often use bonds to pay for their ongoing operations or specific projects, such as highways or new construction.
The borrower (the bond issuer) typically promises to pay the lender (the bondholder), regular interest payments until a certain date. At that point, the bond is said to have matured. When it reaches its maturity date, the full amount of the loan (the principal or face value) must be repaid to the bondholder. Each bond pays a stated interest rate called the coupon, a term that dates back to the days when a bondholder had to clip a coupon attached to the bond and mail it in to receive the interest payment. Most bonds pay interest on a fixed schedule, usually quarterly or semiannually, although some pay all interest at maturity along with the principal. In some cases, the issuer can decide to pay back the loan early by calling the bond and repaying the principal before maturity. The specific terms of a bond are set forth in a bond agreement known as an indenture.
Why do investors buy bonds?
One of the most important reasons why investors choose bonds is for their steady and predictable stream of income through interest payments. Bonds have traditionally been important for retirees for this reason. Also, though they are not risk-free (e.g., a bond issuer could default on a payment or even fail to repay the principal) and individual securities have their own specific risks, bonds as a whole are considered somewhat less risky than stocks. In part, that's because a corporation must pay interest to bondholders before it pays dividends to its shareholders. If it declares bankruptcy or dissolves, bondholders are also first in line to be compensated.
Bond prices may behave very differently from stocks. For example, when stock prices are down, investors often prefer to invest in bonds; this movement is sometimes called a flight to quality because investors prefer the relative stability that bonds and their interest payments offer. Also, when interest rates are high, the return on bonds can be attractive enough that investors become unwilling to assume the greater risk of stocks.
Overview of bond types
Information about bonds is more widely available to the individual investor than it used to be, but navigating the world of bond trading can be challenging without some guidance. However, the wide variety of bonds also means that you can tailor the income-oriented portion of your portfolio to reflect your needs, investing style, and time horizon.
There are many different types of bonds, and an individual bond usually falls into more than one category. A bond can be categorized by who issues it, by maturity date, by quality, by where it's issued, by any restrictions or rights it includes, and by whether any collateral backs up the loan.
Investors in a high tax bracket are often interested in tax-advantaged bonds, which can be issued by state and local governments as well as the U.S. Treasury. An equivalent corporate bond would typically pay a somewhat higher interest rate to attract investors. Some bonds, known as high-yield or junk bonds, offer even higher interest rates because they're considered to be at greater risk of default by the issuer. Foreign governments also issue bonds that can be bought by U.S. investors.
Another important way of categorizing debt instruments is by the amount of time until the loan is repaid. Short-term maturities are typically for less than one year; intermediate-term bonds, often called notes, are generally from 1-10 years. Long-term bonds have maturities of more than 10 years. The 30-year Treasury bond is often referred to as the long bond.