A friend of mine recently asked me a very important question regarding investing: “what are bonds?” Since I work with them every day, I realized I take for granted the basic knowledge of one of the most important parts of any overall investment strategy. Here’s a brief crash course for the uninitiated:
A bond is a contractual agreement to lend someone money and have it be repaid over a specific period of time and at a specific interest rate. The bond is a loan contract. It’s just like that loan agreement you signed when you bought a car or the mortgage you took out when you bought your house. You borrowed money and signed an agreement to pay it back with interest. The investment in a bond is purchasing a loan contract that will pay your money back with interest over a set time.
Why would I want to invest in a bond? The major reason is for certainty. A bond contract sets the time and the amount you will be paid back. These are called fixed income investments because the rate of return on your investment is set by contract. If you hold the bond to maturity you will get your money back plus a series on interest payments. Everything is predetermined.
Does that mean there is no risk in buying a bond? No, just as with stocks or other investment products, there is still risk, although the types of risk are different.
- Default Risk
This risk is that the bond issuer may not pay you back in full and in a timely manner, also known as a default. The issuer could go broke and you would lose money. To avoid this type of risk, you should buy bonds from a highly rated issuer such as the government or a major corporation.
- Liquidity Risk
This is the risk you will not get your money back until the bond matures. If you need to sell the bond before its maturity you might not get your full investment back.
- Re-Investment Risk
This is the risk the bond will only earn the rate of interest specified on the bond, and if interest rates change you are stuck with the rate on the bond until it matures.
Are bonds good investments? If you want certainty in your investment results, they have the potential to be a strong part of your overall portfolio. Bonds provide a regular income flow from the interest payment, and you will get your money back in full if you have chosen a good creditor. The certainty of income and return of principal can be advantageous if you want to live on the investment income, or if you need the principal back at certain times to do things like make major purchases. If you are retiring and want to live on the income from your investments, you should have a large proportion of your portfolio in bonds to generate a steady retirement income. However, if you’re younger and might have a few decades to go until retirement, having a significantly large portion of your portfolio in bonds may not be the best move. For shorter-term investors planning on making a large purchase in a few years like a house or university tuition, then you should have a large portion of your savings in bonds to make sure you have the money on the day you need it.
How can you buy bonds as an investment? If you’re a PERA member, billions of dollars of yours and your fellow members’ contributions are in bonds. As an individual, you can buy a Certificate of Deposit (CD) from a bank or credit union, which are essentially bonds. You can also buy a savings bond from the United States Treasury. You can buy a bond from an investment dealer in large denominations, or you can allocate some of your investment or retirement dollars into a mutual bond fund in your investment account or through your IRA or 401(k) account.
Do you have any follow-up questions on bonds? Leave them in the comments.