5 Crucial Things You Should Know About Bonds

Be honest: How much do you actually know about bonds? If you're stammering for an answer, here's your chance to raise your bond IQ. For starters, bonds are an essential part of every investor's toolkit. They can provide stable returns to help offset volatility in other parts of your portfolio. (See also: The 5 Best Reasons to Start Investing in Bonds Now)

Depending on how old you are, you may not own many bonds right now, but you likely will someday. It's important you at least understand the basics.

1. A Bond Is an "I Owe You"

Shakespeare famously wrote, "Neither a borrower nor a lender be." Apparently, he knew a lot about personal finance (it's definitely best to go easy on the borrowing), but not so much about investing. When you buy bonds, that actually makes you a lender, and this form of lending can be a very good thing, especially as we get older.

When a corporation or government (the two most common issuers of bonds) sells you a bond, it promises to repay the money at a specified future date (known as the bond's "maturity date"). Along the way, it also promises to pay you a fixed interest rate at regular intervals.

Bond issuers use the tool to raise money for their operations. For example, when a local government needs to put in a new $3 million sewer system, it might sell $3 million worth of bonds to pay for the pipes. In essence, it's a way for them to borrow money, possibly for a longer time frame and at a lower interest rate than would be available to them through other means.

You, as a buyer of the bonds, get a fairly safe investment with a known interest rate that is typically higher than you could get through other low-risk investments, such as CDs.

2. Bonds Are Relatively Safe

If you read past Shakespeare's more famous phrase, you'll find this warning, "…For loan oft loses both itself and friend."

As safe as they may be, bonds do come with a risk of financial loss. The two main risks are credit risk and interest rate risk.

Credit Risk

A bond issuer's promise to repay is only as good as the issuer's financial strength. U.S. government bonds are safe as can be. If our country gets in financial trouble, it can just print more money. A start-up company's bonds? Not nearly as safe.

If the issuer of the bond you bought goes out of business, you'll be out the money. That's what's meant by credit risk. You can manage this risk by buying highly rated bonds. Two companies rate the financial strength of bond issuers: Moody's, and Standard and Poor's. Bonds from the most credit-worthy organizations carry a AAA rating. Those with the worst ratings carry a C rating. The better the rating, the safer the bond. The downside is that the interest paid by the safest bonds is typically less than that paid by the lowest rated bonds.

Interest Rate Risk

The other type of risk associated with bonds is interest rate risk. When interest rates rise, the value of an already-issued bond falls. Think of it this way: If newly available bonds are offering a higher interest rate than your bond, why would someone buy yours? You'll have to offer it for less than you paid for it in order to attract a buyer. Of course, for buyers of individual bonds, this only matters if you plan to sell the bond before it matures. Otherwise, you'll still get back what you paid for your bond when it matures as well as the promised interest.

3. Bonds Exist to Lower the Risk of Your Portfolio

One of the most important principles in successful investing is asset allocation. This refers to how you divide your investment dollars across different asset classes, and the two most important asset classes are stocks and bonds. Stocks tend to be riskier than bonds, and over time they tend to generate better returns. When you're young, you have time to ride out the market's ups and downs, so an all- or mostly-stock portfolio is usually the way to go. As long as you can handle the ride, it will typically generate a better long-term return than a more conservative portfolio. (See also: 2 Investing Concepts Everyone Should Know)

As we get older, we can't afford to take as much risk, so it's best to reduce the amount of stocks in our portfolio, replacing them with lower-risk investments, such as bonds. Bonds are designed to lower the risk of your portfolio, smoothing out the ups and downs. The trade-off is they will also typically lower your overall returns.

4. The Easiest Way to Buy Bonds Is Through a Bond Fund

You can buy individual bonds, but it takes time to research the best ones and build an adequately diversified bond position in your portfolio. A much easier way is to buy bond mutual funds. Such funds are inherently diversified.

All of the major fund companies offer bond funds, and you'll find many different types to choose from. There are corporate and government bonds; short-term, intermediate-term, and long-term bonds; domestic and foreign bonds, and more.

You can also buy funds that contain a mix of stocks and bonds, such as target-date funds, which have become a common and popular option in 401(k) and other workplace plans. Such funds come with preset stock/bond allocations, based on how long an investor has until he or she plans to retire.

They also automatically change that allocation over time, shifting away from stocks and toward bonds as the investor gets older. Target-date funds are far from perfect, but they do offer one of the easier ways to manage the use of bonds in your portfolio.

5. Boring Can Be Beautiful

Some people think of bonds as boring, and owning bonds certainly isn't as exciting as owning Tesla stock. But the older we get, the more the steady, low-risk income produced by the bonds become a thing of beauty.

Do you own bonds? Why or why not?

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