If you are new to investing, you may be confused about the difference between stocks and bonds. Financial planners routinely use these terms to describe the portfolios they have built for their clients, but they often fail to define these basic terms. So what is a bond, and what role should bonds play in your own financial planning? Perhaps the most important thing to understand is that a bond is basically a loan, and when you look at it from that perspective it becomes much easier to understand.
When you buy an individual bond, you are essentially loaning money to the company or institution that issued it. In return, you receive a set rate of interest for a specified period of time, and at the end of the term you will (hopefully) get all your money back; read on for the risk factors bond investors need to know about.
Types of Bonds
There is more than one type of bond, and it is important to understand the differences and the relevant risks. Corporate bonds are issued by businesses, from brand name firms you have heard of to smaller companies you may not be familiar with.
If all goes well and the business does well, the money you invest in that corporate bond will be repaid with interest, and you will make money on the investment. But if the firm gets into financial trouble, there is always a risk they will default on your bonds, leading to the loss of some or all of your money.
The bonds issued by the United States government are widely looked upon as the safest, and it is easy to see why that is the case. Since Uncle Sam is in charge of the printing press, it is difficult to envision a scenario where the United States would renege on its obligations and fail to pay back its investors.
In addition to individual bond issues, there are mutual funds that pool money to purchase hundreds, or even thousands of bonds. These bond mutual funds can be a good way to investors to get started, and the built-in diversification serves to reduce the level of risk. There are mutual funds that specialize in government bonds, funds that invest only in corporate issues and widely diversified funds that invest in both government and corporate bonds.
Risk Factors for Bonds
Bonds are usually seen as less volatile than stocks, but they do have their own risks. It is important for bond investors to understand the risks they are taking, including both interest rate risk and the danger of default.
When interest rates rise or fall, the value of bonds moves in the opposite direction. If, for instance, interest rates fall, current bonds will become more valuable, since investors will be looking for those older, higher rates. But if interest rates rise, the value of current bonds will be reduced, since investors can now get more for their money by purchasing one of those new issues.
The risk of default is real as well, especially during uncertain economic times. When the country or the world enters a recession, corporate earnings will often fall, and the firms involved may be unable to meet their financial obligations, including paying back their bond holders. That is why it is important to check the ratings of any company whose bonds you intend to buy; these independent rating agencies can provide real insight into the relative health of the firms and the associated risk of buying its bonds.
Investing in the bond market can be a great way to reduce your overall risk while diversifying your portfolio, but it is important to understand what bonds are and how they work. Now that you know the basics of bonds, you can continue to explore this valuable asset class and make the decision for yourself.