- A bond is a loan you give to a company in exchange for income over a specified period of time.
- Bonds allow individuals to diversify portfolios while reducing investment risk.
- Unlike stocks, bonds usually offer lower returns and do not come with ownership rights.
Although stocks tend to garner most of the excitement behind day-to-day investing, bonds are another important asset class that offers a valuable way to diversify your portfolio.
Bonds are interest-bearing securities that represent the ownership of debt and act as loans between a company or a government and an investor. They are safer and less volatile than shares, offering predictable but often lower returns.
How do bonds work?
A bond is a loan from a lender – like you, the investor – to an issuer, like a company or a government. In return, the issuer agrees to pay the principal of the loan, plus interest, within a specified time period.
Unlike stocks, which represent equity in a company, bonds represent the ownership of debt. In the event that a company goes bankrupt and investors are repaid, debt holders are prioritized over shareholders, making bonds a safer investment than stocks.
Bonds are issued by governments that need funding for day-to-day operations, and companies that want to grow and develop their businesses, but lack the funds necessary for equipment, research, salaries and more.
When do bonds mature?
A bond’s maturity is the length of time a bondholder receives interest payments and correlates with an investor’s risk appetite. Generally, the longer the bond’s maturity, the less volatile the price will be on the secondary market and the higher the interest rate.
Bonds are grouped into three main categories, based on how quickly they pay back investors:
- Short-term bonds: One to five years
- Medium-term bonds: five to 12 years
- Long-term bonds: 12 to 30 years
The duration of the bond measures both how long it will take an investor to recoup the bond’s price and how price-sensitive the bond is in response to changing interest rates.
“One of the disadvantages of bonds is that they are very affected by interest rates, so if you buy a long-term bond, you will be more exposed to prices going up and down based on interest rates,” says CFP Luis Rosa.
Higher duration usually means that the bond price is more likely to fall when interest rates rise, indicating higher interest rate risk. A bond with a duration of three years, for example, will fall 3% as a result of a 1% increase in interest rates, since bond prices typically change about 1% in opposition to interest rates for each year of duration.
Types of bonds
Bonds can come from many different types of issuers. Generally speaking, there are four main categories of bonds:
- Corporate bonds are issued by companies looking to grow, and appeal to businesses because they often offer lower interest rates than banks.
- Municipal bonds are issued by states and municipalities to finance day-to-day operations and projects such as schools, highways or sewage systems.
- Government bonds is issued by the US Department of the Treasury on behalf of the government, and is also referred to as government debt. They are usually used to finance new projects or government infrastructure.
- Agency bonds are issued by government-affiliated organizations and typically pay slightly higher interest rates than U.S. Treasuries.
Rosa advises investors to consider their risk tolerance when deciding which type of bond is right for them.
“If you’re risk-averse, you might want to invest in something a little safer, like U.S. Treasury bonds backed by the federal government, and if you’re in a higher tax bracket, you might want to consider municipal bonds, where you can get a little tax-free income, says Rosa.
Bond credit ratings
In the same way that credit scores indicate a person’s creditworthiness, bonds are evaluated by agencies to assess the issuer’s ability to pay interest consistently and repay the loan by the agreed-upon maturity date.
Ratings are based on the issuer’s financial health, and bonds with lower ratings are known to provide higher returns to investors, to compensate for the additional risk they take.
The three main bond rating agencies are Moody’s, Standard & Poor’s (S&P) and Fitch. Higher-rated bonds, also known as investment-grade bonds, have a rating of “BBB” or higher. This means that the bond is seen as less risky because the issuer is more likely to repay the debt. However, the trade-off is often a lower return.
S&P, Fitch and Moody’s investment grade ratings
Bonds rated “BB” and below are considered “speculative” or “junk bonds.” These issuers usually offer higher returns to offset the risk. It is worth noting that reviews are not set in stone. Agencies can update their ratings, and whether there is an upgrade or a downgrade can affect the bond’s price.
S&P, Fitch and Moody’s non-investment grade ratings
Advantages of bonds
Bonds are usually less volatile than stocks, because investing in debt gives you priority over shareholders in the event of bankruptcy. While a typical retail investor has the chance to lose everything if a company goes under, debt holders can still get some of their money back. On top of that, bonds tend to perform well when stocks don’t, since when interest rates fall, bond prices rise.
Bonds also offer the promise of regular, predictable returns. This sense of security can be especially beneficial during some stages of the economic cycle, such as a bear market, so bonds balance out periods of decline that affect other investments.
Interest rates on bonds tend to be higher than the deposit rates offered by banks on savings accounts or CDs. Because of this, for long-term investments, such as college savings, bonds tend to offer higher returns with little risk.
Investors should consider both interest rates and time horizons when deciding whether to invest in stocks or bonds.
Disadvantages of bonds
Bonds’ predictable returns can be a double-edged sword; Although creditors are guaranteed regular payments, there is no chance of “winning big” as you might with stocks.
Unlike stocks, bonds do not give investors any ownership rights. They simply represent a loan between the buyer and the issuer, meaning you will have no say in exactly where your money goes.
As previously mentioned, the inverse relationship between bond prices and interest rates can also be considered a disadvantage, since market volatility means constantly fluctuating bond prices.
What you should know before you invest
There is a lot to consider when deciding whether to invest in a bond versus another financial investment. Here are some things to keep in mind:
- Timing is key. Because bond values fall when interest rates rise, if you’re thinking about selling a bond, the timing can make a big difference in your payout. If you sell a bond when interest rates are lower than when you first bought it, you can make money. On the flip side, if you sell when interest rates are higher than at the time of purchase, you are likely to incur some loss.
- The bond issuer’s creditworthiness affects the interest rate. As previously mentioned, bond rating agencies account for the likelihood that an issuer will default on payments, and different types of bonds are generally associated with varying levels of risk. US Treasury bonds are among the safest investments, followed by state and local government bonds, and then corporate bonds. Less reliable issuers, such as a new company without much experience, may issue higher interest rates to compensate for their risk of default.
- Bonds are exposed to inflation risk. Although bonds are often considered a safe and reliable investment, they are still subject to inflation risk, as they typically pay fixed interest rates despite changing consumer prices.
Consider built-in options
Embedded options give either the holder or the issuer of a security certain rights that can be exercised later in the life of the transaction, such as selling or calling back a bond before the maturity date. These options can be linked to any financial security, but are most often linked to bonds.
Here are some built-in options related to bonds:
- Callable bonds can be “called back” by the company before the maturity dates, and then reissued later at a lower coupon rate. These are riskier for buyers, since bond issuers are more likely to call a bond when it rises in value.
- Puttable bonds work in the opposite direction, allowing creditors to sell the bond back to the issuer before it has reached maturity. This makes sense when investors expect an increase in interest rates and want the principal back before the bond’s value falls. These usually trade for more than non-depositable bonds.
- Zero coupon bonds do not pay coupon payments and instead are issued at a discount to face value that will generate a return when the bondholder is paid the full face value when the bond matures. US Treasury bills are a zero-coupon bond.
- Convertible bonds uniquely allow bondholders to convert their bonds into shares if they expect the share price to eventually rise above a certain value.
Another available option when it comes to buying bonds is to invest in bond funds rather than individual bonds.
“They trade every day, so you don’t have to wait until maturity if you need your money for any reason,” says Rosa, adding that they are professionally managed and offer more diversification than a single bond.
The bottom line
Bonds are a unique asset class that represents the ownership of debt in a business or government entity. They are safer and less volatile than shares, and offer the promise of regular, predictable returns.
Despite their advantages, bonds also tend to yield lower returns than stocks and do not come with any ownership rights. Be sure to consider your time horizon and risk tolerance when deciding whether to invest in this asset.