A bond is a type of debt security that you buy from either a corporation or a government that is trying to raise money. It’s essentially a loan that you are repaid, with interest, in regular, fixed payments for a set time.
Bonds are considered a low-risk asset that can provide investors with a way to diversify their portfolio away from more aggressive assets like stocks. Investors often use bonds to preserve their capital while earning predictable income.
However, bonds do have downsides to consider, such as credit risk, inflation risk, and other risks. Read on to learn how bonds work, compare the pros and cons of investing in bonds, and find out how they compare to stocks.
How Bonds Work
Corporations or governments issue bonds to raise funds for any number of reasons, from providing operating cash flow to funding public projects like schools or infrastructure.
Investors buy bonds for the predictable income stream and to preserve capital as bonds are considered fairly low risk. Bonds can also help diversify a portfolio that is heavily focused on stocks, which have more volatility. When you buy a bond, you agree to the interest rate and terms of the contract. For example, you may buy a 10-year bond with a 3% interest rate. The issuer will then make regular payments to you, typically twice a year, that include principal and interest. By the end of the term, you will have your original invested amount repaid, plus interest.1
You can also sell bonds before their maturity date. Depending on broader market conditions, a bond’s face value may increase or decrease, so you could gain or lose money if you sell early.
Some bonds also offer tax advantages. For example, the interest on a municipal bond is tax-exempt from federal income taxes and often state and local income taxes as well.
What Are Bond Risks?
While considered a safe investment, bonds do carry risks just like other investments. Here are some common bond risks:2
- Interest rate risk: The risk that rising interest rates will lower the face value of the bond. If new bonds offer higher interest rates, buyers will favor those bonds over older bonds and investors will have to sell older bonds at a discount. Interest rate risk is only a risk to investors who want to sell their bonds before the maturity date.
- Credit risk: The risk that the issuer will default, and the investor will not receive interest or principal payments. Credit rating agencies like Standard & Poor’s, Moody’s, and Fitch rate bonds for their creditworthiness.3
- Inflation risk: The risk that price increases in goods and services will reduce the purchasing power. If a bond’s interest rate does not keep up with the inflation rate, the investor essentially loses money.
- Liquidity risk: The risk that an investor may struggle to sell a bond amid low demand. Liquid assets are those you can exchange for cash quickly. If you cannot find a buyer, you may not be able to sell your bond when you want.
- Call risk: The risk that the issuer can “call” a bond, or retire it, before its maturity. An issuer may call a bond amid lower interest rates so they can issue new bonds at lower rates and save money.
Bonds vs. Stocks
You can use a combination of stocks and bonds to create a diversified portfolio toward your investment goals. Investors often use bonds to offset the volatility you might see with stocks.
Bonds are considered lower-risk assets than stocks, but they also tend to provide more modest gains. Stocks, on the other hand, are higher risk than bonds but they have the potential for greater returns. A stock or share represents an ownership stake in a company. As the company performs well, shareholders often benefit as the market price of the stock increases amid higher demand. Similarly, if it performs poorly, the stock can lose value.4
Types of Bond Investments
Investors have a range of bond types to choose from. The common bond types include:
- Corporate bonds issued by corporations to raise money for a range of purposes like buying new equipment, paying dividends, or investing in research and development.
- Municipal bonds issued by states, cities, counties, or other governments typically to fund public projects or for day-to-day operations.5
- U.S. Treasury bonds issued by the U.S. Treasury Department on behalf of the federal government.
Most bonds are classified as either investment grade or non-investment grade (sometimes called “junk” bonds) based on their credit rating. Investment grade bonds are considered lower risk and tend to provide lower returns. Non-investment grade bonds are higher risk, and they generally offer higher interest rates.
The Bottom Line
Bonds can be a key part of a balanced trading strategy, with advantages like predictable income and capital preservation. Consider consulting with a financial professional for guidance on which bonds may suit your investing goals, risk tolerance level, and financial situation.
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A diversified portfolio does not ensure a profit or protect against loss in a declining market.
1 Investor.gov, “Bonds: What Are Bonds?” https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds
2 Investor.gov, “What Is Risk?” https://www.investor.gov/introduction-investing/investing-basics/what-risk
3 Investor.gov, “Investment-Grade Bond (or High-Grade Bond)” https://www.investor.gov/introduction-investing/investing-basics/glossary/investment-grade-bond-or-high-grade-bond
4 Investor.gov, “Stocks: What Are Stocks?” https://www.investor.gov/introduction-investing/investing-basics/investment-products/stocks
5 SEC.gov, “What Are Municipal Bonds” https://www.sec.gov/munied