You may have heard that a balanced investing portfolio includes both stocks and bonds, with the ratio between the two varying depending on your age and risk tolerance. Most financial advisors will recommend increasing the proportion of bonds in your investment portfolio as you get closer to retirement, the better to counterbalance the risk of a market crash wiping out your net worth. But what exactly is a bond, and how does it work as an investment? Whatever your age, understanding how bonds works and how they should fit into your portfolio is crucial.
What Is a Bond?
A bond is a type of investment in which you as the investor loan money to a borrower, with the expectation that you’ll get your money back with interest after your term length expires. Bonds are a type of fixed-income investment, which means you know the return that you’ll get before you purchase. Bonds can be issued, meaning put up for sale, by the federal and state government as well as companies.
Bonds are one of two ways you can invest in a business. The other is to buy a company’s stock. While bonds represent a debt investment – the company owes you money – stock represents an equity investment, which means you own part of the company.
How Do Bonds Work?
When you buy a bond, you’re lending money to the entity that issued the bond, whether that’s a company or a government. Since you’re lending, that means you’re entitled to collect interest. When the bond matures, you’ll get back the money you paid for the bond, known as the principal or the par value, and you’ll also get interest on top of it.
When you’re shopping for bonds, you’ll be able to see each bond’s price, time to maturity and coupon rate. The coupon rate is the annual money you’ll receive, expressed as a percentage of the principal that you pay to buy the bond. Coupon rates for new bonds hover around the market interest rate.
So, if you purchase a two-year bond with a par value of $1,000 and a coupon rate of 4%, then you would earn $40 in interest for each year of the term and $80 in total interest. Most bonds will pay out interest twice a year on what are called coupon dates. This is fairly straightforward, but things get more interesting when we think about reselling these bonds on the secondary market.
The Bond Market
The bond market is sensitive to fluctuations in the interest rate. What do we mean by “the” interest rate? There are lots of different interest rates, for things like home mortgages and credit cards, but when someone refers to “the interest rate” or “interest rates” in a general way, they’re referring to the interest rate set by the Federal Reserve. This is also known as the federal funds rate.
The Fed uses its power to buy and sell Treasury Bonds to affect interest rates. When the Fed sells Treasury Bonds, it’s taking money that would otherwise circulate in the economy. Cash becomes more scarce, which makes borrowing money relatively more expensive and therefore raises interest rates. Interest rates are the cost of borrowing money. The interest rate that the Fed decides on as a target has a knock-on effect on other interest rates, including your mortgage rate and the rates on bonds.
When the general interest rate goes up, the price of existing bonds falls. In other words, interest rates and bond prices have an inverse relationship. Think of it this way: If interest rates rise, new bonds that are issued will have a higher interest rate to reflect this change. If you go to sell a bond that has the old, lower interest rates, you’ll have to lower its price to get anyone to buy it. That’s because the opportunity cost of holding your old, lower-coupon-rate bond has risen. Potential buyers will think, “Why pay $1,000 for a bond paying 4% when I could pay $1,000 for a bond paying 5%?”
Risks of Bonds
The relationship described above means that bondholders are subject to interest rate risk. This is the risk that changes in the interest rate will make the bonds they hold less valuable, leaving them with assets they’d have to sell for less than they paid for them. Bonds come in short-term and long-term forms. The longer the term of your bond, the more uncertainty there is about what interest rates will do in the duration. Of course, changes in the price of your bond are only a problem if you sell before maturity. If you hold onto your bonds, you’ll get your principal back – unless the issuer becomes unable to pay.
That brings us to another risk that comes with buying bonds – namely, the risk that the company or government issuing the bond will default, leaving bondholders to scavenge what’s left of the company’s assets. This is called credit risk. Bonds are rated by rating agencies that give issuers a grade based on their likelihood of default. As you might expect, “junk bonds” are bonds that are judged to have a relatively high risk of default. Interest rate risk is more common among corporate bonds; there’s little chance of a government (especially that of a large developed country, like the US) defaulting on its debt obligations.
Finally, bonds are subject to inflation risk. If you buy a bond that pays 2% and inflation is at 2.4%, you’re essentially losing money by holding that bond. People often look to bonds as a safe investment. However, in a low-interest rate environment, the interest that bonds pay may not top inflation rates. Sure, you’re very unlikely to lose your principal if you invest in a safe bond like a Treasury bond. However, your money might not be growing.
How to Buy Bonds
You can buy Treasury bonds directly from the US Treasury through its site Treasury Direct. To buy other types of bonds, including municipal bonds and corporate bonds, you’ll go through a brokerage. This could be an online-only brokerage that charges a fee per trade, a brokerage firm that charges low fees as a percentage of your assets or a full-service brokerage that charges higher fees but offers more in the way of financial advice.
You can also buy bond mutual funds, bond ETFs and bond index funds. Bond funds will hold various bonds in pursuit of higher returns and diversification. A Bond ETF actually trades on the market and offers different tax advantages to bond mutual funds. Bond index funds charge lower fees because they’re passively managed as opposed to actively managed. They aim to mirror or “index” the overall bond market.
There are also mortgage bonds, backed by real estate mortgages. These are the mortgage-backed securities (MBSs) that became notorious during the financial crisis. Many mortgage bonds are dependable investments, but others are based on mortgages with a high risk of default. In other words, choose wisely.
A bond with a high rating offers dependability and certainty. But in the investing world, lower risk tends to mean lower return. That’s why bonds don’t offer the kinds of returns you’ll get if you invest in stock. The lower volatility of bonds means that most investors choose to balance their portfolio with a mix of bonds and stocks.
The closer you are to retirement, the less time you have to weather ups and downs in the stock market. That may mean you want to decrease your equity exposure and increase the share of your portfolio that’s in bonds as you approach retirement. You want the money that forms the basis of your retirement income to stay constant or grow.
Tips for Smart Investing
- A financial advisor can help you create a balanced portfolio with a blend of bonds and other investment types. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Bond investing is a great way to adjust the risk tolerance of your overall portfolio, but it can be tricky to find the exact balance you want. SmartAsset’s asset allocation calculator can help you understand how risk tolerance influences your investing decisions.
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