In the financial world, stocks tend to get most of the attention. But if youre going to make progress toward all your long-term goals, you need to be aware of all types of investments – and bonds can be an important part of your portfolio.
Many people, however, dont fully understand how bonds work. So, before you invest in them, familiarize yourself with the bond basics. Here are a few of them:
* Bonds are debt instruments. When you buy shares of stock, youre actually becoming an owner – although one of a great many – of a company. But when you purchase bonds, you are, in effect, loaning money to whomever issues the bond – a business or the government. If you hold the bond until it matures, youll get your principal, or par value, back (provided the issuer doesnt default) and, along the way, youll receive regular interest payments. A bonds interest rate is known as the coupon.
* Bond prices will fluctuate. Your bonds interest rate will not change over the life of the bond. However, the price of your bond can fluctuate, an important factor to keep in mind if you plan on selling your bond before it matures. A bonds price will move in response to several variables, chief among which is interest rates Bond investments are subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease and the investor can lose principal value. For example, suppose you own a $1,000 bond that pays a 4 percent interest rate. If new bonds are issued at 5 percent, no one will pay you the full $1,000 for your 4 percent bond, so, if you wish to sell, you will have to offer it at a discount. Conversely, if market rates fall to 3 percent, your 4 percent bond will become highly desirable, so you could sell it for more than the $1,000 par value.
* Different bonds have different ratings. If you buy a corporate bond, youll have a choice between investment grade bonds – those receiving the higher grades issued by rating agencies, such as Moodys or Standard & Poors – and junk bonds – those getting the lowest grades. The higher-quality bonds carry less risk of default but pay a lower interest rate than the junk bonds, which must offer the higher rates to attract investors who may be worried about default risk. Generally speaking, youre probably better off by sticking with investment grade bonds and staying away from the junk.
* Some bonds can be called. A callable bond is a bond that can be redeemed – or called – by the issue before its maturity. If interest rates have declined since the bond was originally issued, companies will call bonds and reissue them at the lower, prevailing interest rate, thereby saving money on interest payments. As an investor, this could be cause for concern, because if your bond is called, and you wanted to reinvest the proceeds in a new bond, youd likely have to accept a lower coupon rate. Consequently, you may want to look for a bond that offers call protection – a promise that a bond cant be called before a certain time.
To determine if bonds are appropriate for your individual situation – and, if so, what type of bonds – see your financial advisor. By adding bonds to your portfolio, you may well give yourself a broader platform for success.