So, what are bonds? Bonds are one of the three basic building blocks of asset allocation. Investors seeking investment advice are often shown pie charts of portfolio allocations broken down into three primary categories: stocks, bonds and cash.
And bonds are an integral part of those models, and investing overall, for a number of reasons. You see, unlike a stock, which provides the shareholder with “equity” or ownership in a company, bonds are “debt”; the bond issuer owes the bondholder money. And that means the investor, by purchasing the bond, has loaned money to the issuing entity. In return for the loan the bondholder receives interest payments, referred to as the “coupon”. These coupon payments are to be made for a specified time period at a fixed interest rate. At the end of the predetermined time period, when the bond has reached “maturity”, the bondholder receives the loaned amount, or the “principal”, back.
Bonds are issued by many different entities including corporations, state and local municipalities, and the United States and foreign governments. And the money raised through a bond offering can be used for many different purposes. A corporation might issue a bond to fund the expansion of its business while a state government might issue a bond to finance the construction of a highway. Whatever the purpose, the bond buyer needs to know all about the bond before making an investment.
What are Bonds: Part II
You see, not all bonds are created equal, and some are riskier than others. A bond issued by the United States government, called “treasuries”, are considered by many to be risk free. That’s due to the fact that the government has unlimited resources and won’t default, or fail to pay, either the interest or the return of principal.
State governments and local municipalities, and many foreign governments, also issue bonds but they generally do not have the same resources as the US government. Accordingly, many of those bonds are not as low risk as the US governments bonds and therefore pay higher yields. Corporate bonds also have different levels of risk. Some companies are in better financial condition and are more capable of meeting their debt obligations.
That’s why there are bond ratings organizations. These companies analyze bond issuers for their financial strength and publish ratings to help investors choose the right bonds. The three biggest ratings agencies, Standard & Poor’s, Moody’s and Fitch, rate bonds from the best, Standard & Poor’s ranks these bonds AAA, to the worst, what are called “junk” or “high yield” bonds, BBB or lower according to S&P…
The riskier the bond, the higher the rate of interest it should pay, since there is a greater risk of default. And default means you might not get the coupon payment. In a worst case scenario, you might not get the principal back either. Investing in bonds takes more research than some might expect. Therefore many investors, in order to protect themselves and to minimize the work necessary to be confident they are buying the right bonds, choose to invest in bond mutual funds and ETFs (exchange traded funds).
By doing so, much of the risk associated with owning individual bonds is mitigated. You see, bond fund portfolios are usually comprised of dozens, and at times hundreds, of different bonds, which means that if any single bond defaults, the impact on the portfolio is minimized. There are many different kinds of bonds. Familiarizing yourself with them, and the risks and rewards they each present, will help ensure your success as a bond investor.
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