Bond Investing 101: How bonds work and why they belong in a balanced wealth-building portfolio

how bonds work

The stock market keeps hitting all-time highs and setting records that are rewarding investors. Students of history know, however, that stratospheric climbs often portend a looming market correction, or the end of the bull run and the start of the next bear market cycle. This is where it pays to understand how bonds work.

One way experienced investors safeguard their portfolios is by diversifying into bonds because when stocks fall, the value of bonds often rises, making quality bond holdings a good buffer against stock market losses. Bonds are also an appropriate investment to help manage interest rate volatility because when prevailing interest rates fall, bond prices rise, and when rates go back up again bond prices become cheaper.

A prudent way to invest in bonds is to hold them for the long haul, until they reach maturity. Once the maturity date is reached you are entitled to the original face value of the bond plus any interest you have earned along the way.

What Are Bonds?

Bonds are a sophisticated form of I.O.U. and they are issued by both government entities and corporations. You can buy bonds issued by the United States Treasury, for instance, and they are regarded as the safest bonds in the world because they are backed by the full faith and credit of the United States government.

Treasury bond interest is exempt from state and local taxes, too, but not from federal tax. Bonds are also sold or issued by cities that use them to raise money for municipal projects. To save on taxes you can buy tax-exempt municipal or “muni” bonds. One way to determine whether that would save you money is to look at the interest rate you hope to earn on the bond, and then compare that to your tax rate. People in a higher tax bracket, for example, may have their bond earnings undermined by having to pay taxes on those earnings. In that case, a tax-free “muni” bond may make more sense.

You can also buy bonds from companies of various sizes that operate in all different kinds of industries. To incentivize investors to buy their bonds, those who issue them promise to make annual interest payments to bondholders.

Bonds also have a face value. When the bond reaches its maturity date the issuer pays you the bond’s face value – which is equal to the original principle you “loaned” them. As far as terminology goes, the price when issued, or face value, is also referred to as the bond’s “par value.” The interest payment is called a bond “coupon.”

How a Bond Pays Interest

Not all bonds are the same, which cause bond interest to differ as well. Say, for instance, that abond promises to pay 2% per year and has a par value of $1,000. That means it would have a $20 coupon. Interest would likely be paid in two separate payments of $10 each – paid six months apart.

Some bond interest is on a different timeline such as quarterly or even monthly. Here are a few examples of how bond interest differs:

  • Structure payments by buying mutual funds that invests in bonds. You can choose funds that pay at different times in order to ensure a steady stream of payments throughout the years. Bonds are popular with retirees, for instance, because of this ability to schedule payments that help provide a regular stream of income.
  • Some bonds have floating or variable rates, which means that their interest rates adjust with market conditions.
  • If you hold the bond to maturity you can also cash it in for the $1,000 face value. In the meantime, though, another investor may offer you a higher price in exchange for your bond.
  • Bonds can also be bought and sold on the open market, the way stocks are traded. So you may decide to sell your $1,000 bond before it reaches maturity in order to profit from a higher price. In that case you gain the extra money being offered to you plus any interest you have already banked.

It is important to study the terms and conditions of bonds before making an investment to be sure the bond meets your particular goals and needs. You should also review your investment portfolio annually to make sure it remains diversified.

Additional Aspects of Bonds

  • The bond issuer may “call the bond” back if they want to, which means that they will buy it back from you before the actual maturity date. When that happens the issuer usually pays you a premium, and if the interest that was promised on the bond is especially high, the premium may also be quite high.
  • You can also invest in convertible bonds. These offer you the option to convert your bonds into shares of stock, according to the terms of the convertible bond purchase. While convertible bonds usually pay lower interest, the upside is that they give you a flexible investment option in case you want to shift out of bonds and own stocks instead.
  • Rating services such as Standard & Poor’s and Moody’s will assign quality ratings to bonds, and those measurements can be a useful guide when shopping for bonds. An “AAA” rating usually indicates very high quality, for example, while an “AA” rating is slightly lower. A “D” rating would reflect high risk, and might fall into the category of so-called “junk” bonds.
  • If you are not afraid of risk, higher risk bonds usually pay considerably higher interest. Conservative investors can use high interest as an indication that a bond may be too risky, too, since sometimes if the interest is too attractive it could mean that the company is not financially sound – and could go bankrupt before paying interest.

When calculating value, it is important to not just look at the interest paid, but also the potential appreciation (or loss) of value compared to the price you pay for your bond. Also be aware that if you purchase bonds through a broker they may charge a commission fee which will also cut into your gains. If you buy U.S. bonds directly from the United States Treasury, though, you won’t be charged any sales fees.

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