This begins a new series on Investments. Focus on Investments will explore investments basics in a simple and easy to understand manner. We will start the series off with Bonds.
Bonds are an often overlooked part of many investment portfolios. Unlike stocks, bonds are neither considered to be exciting nor are they likely to be the subject of a ‘hot’ tip from a broker or friend. The truth be told, bonds can be boring. But as an investor, even the ‘boring bond’ deserves your attention and understanding. Let me explain some bond basics that investors need to know.
What is a Bond?
Simply stated bonds are IOUs. In exchange for the use of investor money, the issuer pays the investor interest and returns the original investment amount at the end of the term. You may also hear a bond referred to as a fixed-income security. U.S. Savings Bonds are an example of a bond.
In Terms of Risk, Where Do Bonds Stand in Relationship to Cash and Stocks?
Comparing the risk/return profile of bonds to cash and stocks, bonds lie between cash and stocks.
That means that holding cash is less risky and generally pays less than holding a bond. And, holding stocks is generally more risky and often pays more than holding high quality bonds.
When investing, the higher the reward, the higher the risk. An investor is paid for taking risk.***
***So, if you are ever offered a higher return than other bond investments are currently paying, beware! If it sounds too good to be true, it probably is!
Why Buy Bonds?
1. Bonds can be considered to be less risky than stocks.
2. Generally speaking, high quality bonds often have a lower correlation to stocks.
3. Bonds pay a steady income stream and typically pay more than interest bearing savings accounts.
4. Buying bonds can provide tax advantages for high income investors. -Depending on the type of bond purchased, interest received from some issuers can be tax advantaged or in some cases tax free.
Potentials for Bond Buyer ‘Gotchas’
1. Bonds often return less than stocks and may not keep up with inflation.
2. There is a risk of default (mostly with corporate bonds). -If a corporation goes out of business, it may not be able to pay (default) its bond holders their principle or interest.
3. Bond prices fluctuate inversely with interest rates. This becomes an issue in a rising interest environment when bonds are not held until maturity (for the whole term).
On the surface bonds can be deceptively easy. If held to maturity with no company default or call option, the bond will perform as expected. When an individual bond is sold before maturity, it is very important for the investor to understand how interest rates, current bond price, quality of the bond will impact the sale of the bond.
This information is for general financial education purposes only and is not a recommendation for buying or selling bonds. Consult your financial advisor before buying or selling bonds or bond products.
Jane Nowak, Financial Planner and MoneyGal2020 is a Financial Planning and Retirement Specialist for Women. She works at Kring Financial Management in Atlanta, GA Follow her on Twitter at: MoneyGal2020 and her Blog
Andrea is the Chief Chick of Smart Money Chicks. After filing BK twice (once because she panicked, second time because the pro messed the first time up), she realized that it all could have been avoided if she understood more about how her Finances worked and the options available. At that point, she wanted to help as many as she could never make the same mistakes again. Our Promise is that all the content you read on here is created or edited by Andrea
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