Now that you are ready to begin investing, have you ever wanted to ask, “What is a bond?” or “How do you invest in bonds?”. If so, this was written specifically for you. In the next minute or two, you are going to get a basic overview of how bonds work, who (and by whom) they are issued, the basic appeal of investing in bonds, and some of the major considerations you’ll want to factor into any allocation decision should you decide to add them to your portfolio.
What Is a Bond?
First thing is first: What is a bond? As you learned in Bonds 101 – What They Are and How The Work, a bond, in its basic form, a plain vanilla bond is a type of loan. An investor takes his or her money and temporarily lends it to the bond issuer. In exchange, the investor receives interest income at a predetermined rate (the coupon rate) and at predetermined times (the coupon date). The bond has an expiration date (the maturity date) at which point the stated par value of the bond must be returned.
In most cases, with a notable exception being certain U.S. Government savings bonds such as the Series EE savings bonds, a bond ceases to exist at maturity.
What Are the Different Types of Bonds an Investor Can Acquire?
Although the specifics of any particular bond can vary wildly – at the end of the day, a bond is really just a contract drawn up between the issuer (the borrower) and the investor (the lender) so any legal provision upon which they might agree could theoretically be put into the bond indenture – certain ordinary customs and patterns have emerged over time.
Sovereign Government Bonds – These are bonds issued by sovereign governments. In the United States, this would be things such as U.S. Treasury bills, bonds, and notes, which are backed by the full faith and credit of the country, including the power to tax in order to meet its constitutionally required obligations. Additionally, sovereign governments often issue special types of bonds aside from their primary obligations.
Municipal Bonds – These are bonds issued by state and local governments. In the United States, municipal bonds are often tax-free to achieve two things. Firstly, it allows the municipality to enjoy a lower interest rate than it would otherwise have to pay (to compare a municipal bond with a taxable bond, you must calculate the taxable equivalent yield, which is explained in the article linked earlier in this paragraph), easing the burden to free up more money for other important causes. Secondly, it encourages investors to invest in civic projects that improve the civilization such as funding roads, bridges, schools, hospitals, and more.
Corporate Bonds – These are bonds issued by corporations, partnerships,limited liability companies, and other commercial enterprises. Corporate bonds often offer higher yields than other types of bonds but the tax code is not favorable to them.
What Are the Main Risks of Investing in Bonds?
Although far from an exhaustive list, some of the major risks of investing in bonds include:
Credit Risk – Credit risk refers to the probability of not receiving your promised principal or interest at the contractually guaranteed time due to the issuer’s inability or unwillingness to distribute it to you.
Flation Risk – There is always a chance that the government will enact policies, intentionally or unintentionally, that lead to widespread inflation. Unless you own a variable rate bond or the bond itself has some sort of built-in protection, a high rate of inflation can destroy your purchasing power as you may find yourself living in a world where prices for basic goods and services are far higher than you anticipated by the time you get your principal returned to you.
liquidity Risk – Bonds can be far less liquid than most major blue chip stocks. This means that, once acquired, you may have a difficult time selling them at top dollar. This is one of the reasons it is almost always best to restrict the purchase of individual bonds for your portfolio to bonds you intend to hold until maturity.
Reinvestment Risk – When you invest in a bond, you know that it’s probably going to be sending you interest income regularly (some bonds, known as zero-coupon bonds, do not distribute interest income in the form of checks or direct deposit but, instead, are issued at a specifically-calculated discount to par and mature at their face value with the interest effectively being imputed during the holding period and paid out all at once.