What are bonds?
In the most simple terms, bonds are loans. A corporation can raise money by issuing bonds, while governments will often use bonds to pay for ongoing operations or specific projects.
Regular interest payments are paid to the bondholder by the bond issuer until a certain date, after which the bond is matured. When the bond matures, the full loan amount must be repaid to the bondholder. Most bonds pay a stated interest rate on a fixed schedule (quarterly or semiannually), although some actually pay the full interest at the time of maturity, along with the principal. In some instances, the issuer can pay back the loan early, repaying the principal before maturity.
Bonds are issued evenly, usually in amounts of $1,000 or more, and can be traded between investors if you don’t hold the bond until maturity. Bonds are negotiable. This means when an investor buys one, the issuer owes that investor interest and principal. At first, the person buying bonds pays the exact amount of the face value, which means the bond is being traded at par. When the buyer pays bond prices that are more than face value, the bond is selling at premium (discounted).
While some investing in bonds prefer buying individual bonds, others choose to invest in a bond mutual fund or an exchange-traded fund, also known as an ETF.
What kind of returns do bonds provide?
As market conditions change, the principal value of bonds may fluctuate with those changes. Bonds that are redeemed prior to maturity may be worth more or less than what the buyer originally paid for them. Bond funds and ETFs are subject to the same interest-rate, inflation and credit risks associated with the underlying bonds within them. During periods when interest rates rise, bond prices typically fall, something that can adversely affect a bond fund’s performance.
People are investing in bonds for a variety of reasons:
- Bonds are typically considered to be less risky than stocks, providing a more steady and predictable alternative
- Investors often invest in bonds when stock prices are down
- Bonds can increase the stability of your overall portfolio, as interest from the bonds helps balance the ups and downs associated with stock investments
- Since a bond’s face value gets repaid when the bond reaches maturity, investors can choose a bond that matures at a time when they anticipate they will need that money.
- There are tax advantages associated with some bonds. Interest from bonds that are issued by state and local governments is exempt from federal income tax and may also be exempt from state income tax.
- Bond holders can profit from their bonds via the interest that bonds pay if you sell a bond for profit or before its maturity date. The closer to the maturity date, the closer the price is to face value.
Bonds come in a variety of types
- Individual bonds can fall into multiple categories based on who issues them, maturity date, quality, where they are issued and whether any collateral backs up the loan or there are any restrictions or rights included.
- Tax-advantaged bonds issued by state and local governments or the U.S. Treasury.
- Corporate bonds, which typically pay a higher interest rate in order to attract investors.
- High-yield or junk bonds offering even higher interest rates.
- Bonds issued by foreign governments that can be bought by U.S. investors.
Different bonds also come with different maturities. Short-term maturities are typically for less than one year; intermediate-term bonds are usually from 1-10 years and long-term bonds have maturities that exceed 10 years. The 30-year Treasury bond is quite often referred to as the long bond.
Considerations before buying bonds
There are several factors that should be considered when evaluating bonds:
- Income needs
- Tax bracket
- Time horizon
- Resources to allow for diversification
- Comfort with volatility
How to purchase bonds
Bonds are often bought through a broker or a financial advisor who can help you to determine the best strategy for your bond portfolio. Treasury securities also can be bought directly from the U.S. government. You can learn more about the TreasuryDirect program at www.treasurydirect.gov.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
And investor can lose money when investing in government bond funds. Fund itself is not guaranteed and fund’s performance will vary.
Investing in mutual funds involves risk, including possible loss of principal.
An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts and index tracking errors.
This information is not intended to be a substitute for specific individualized tax advice. We suggest you discuss your specific tax issues with a qualified tax advisor.