Stocks and bonds are like the salt and pepper of the investment world — they’re both key ingredients of a well-seasoned portfolio. And depending on your investment goals, your portfolio might need more of one or the other.
But what is a bond, and why would your portfolio need more or less of what they offer?
Bonds are loans that investors make to companies, agencies and governments. While stocks tend to get the most hype for their wild price movements, bonds can offer steady income and reasonable rates of return — and with less risk than stocks.
Bonds are securities that are, in the simplest terms, loans between an issuer (the borrower) and you (the lender).
When you buy a bond, you become the bank and lend money to a company or government entity. In exchange for your loan, those entities agree to pay you interest (your coupon payment) for the term of the loan until the loan is paid in full — which could be right on time or early, depending on the bond variety (more on bond varieties in a minute).
Your interest payments can be made at various intervals, such as quarterly, semiannually or annually. A bond’s prospectus, also known as an offering document, spells out the frequency of and dates for your coupon payments.
A wide range of entities issue bonds for various reasons. If a city needs a stadium built? It issue bonds. And if a public company needs cash to fund a new expansion? It issue bonds, too.
These are the most common types of bonds — named for the entity issuing them — and what the money raised typically funds:
Most bonds work like a typical loan — there’s an amount borrowed at a set interest rate for a fixed term. Here’s a step-by-step guide to how bonds work:
Let’s say you buy a new $1,000 bond from Big Search Engine Company (BSE Co.) with a 10-year term and 5% annual coupon. That means that each year, you’ll receive a $50 interest payment ($1,000 x 5%). Then, at the end of 10 years (your bond’s maturity date), BSE Co. will give you your original investment of $1,000 back … unless they go bankrupt.
(Although, big search engine companies tend to have staying power, so we wouldn’t be too worried about this company’s future.)
Let’s expand on the three-step process outlined above by defining some important bond terms you need to know. These terms relate to every bond issued in the marketplace:
Absolutely. Having different bond varieties to choose from lets you customize the type of bond you buy according to your financial goals and risk tolerance. These are some of the most popular bond varieties you’ll encounter on the bond market:
Also referred to as redeemable bonds, the issuer may call upon these bonds before the maturity date. A bond’s prospectus will clearly state whether it’s callable and at what points the issuer can pay off (call) their bonds.
The opposite of callable bonds, puttable bonds (also known as put bonds) allow you to redeem your bond early with the issuer. Your prospectus will clearly state the early redemption date(s).
Convertible bonds allow you to convert the money you invested in a corporate bond into shares of the issuing company’s stock at a predetermined price.
Also known as floating rate bonds, variable rate bonds adjust their interest rates periodically based on the interest rate index they’re linked to — the LIBOR index is one example.
Unlike most bonds, these bonds don’t offer regular coupon payments throughout their terms. Instead, you purchase zero-coupon bonds at a discounted rate (below face value). At maturity, you then redeem your bond for full face value. The difference between your discounted price and the bond’s face value will be your profit.
Bonds come with several advantages that can make them a sought-after, low-risk investment, including:
While bonds are widely considered less risky investments than stocks, they also have downsides. These might include:
What’s good for one person might not be good for another. The more important question is, “Are bonds a good investment for you?” The answer has to do with what you need as an investor and where you are in your investment journey.
Bonds could play more of a role in your portfolio if:
Bonds might play less of a role in your investment portfolio if:
There’s rarely a portfolio that wouldn’t benefit from some sort of exposure to fixed income like bonds. For you, it’s all about finding the mix of equities (like stocks) and fixed income (like bonds) that make the most sense for your investment goals, time horizon and risk tolerance.
If you’re curious about what your ideal portfolio mix of stocks and bonds might look like, check out our in-depth look at asset allocations by age. You can also find a financial advisor who can review your finances and help you build an asset mix designed to grow with your goals over time.
Now you know the basics about what bonds are and how they work — and if you decide to tell a friend about bonds, you won’t give an answer that has to be taken with a grain of salt. As for the question of whether bonds make good investments, it all depends on your circumstances. In general, however, bonds (like pepper) shouldn’t be your main course, but adding some in the mix is a great way to season a well-diversified portfolio.
What are I bonds?
Series I bonds are savings bonds issued by the U.S. Treasury with interest rates tethered to current inflation rates. An I bond’s interest rate adjusts every six months to reflect the current inflation rate.
Can you sell bonds on the secondary market?
If you want to sell your bond before its maturity date, you can sell bonds on the secondary market. Secondary markets can be organized exchanges, like those offered by online brokerages. Over-the-counter markets are another example of a secondary market, where a broker-dealer network matches buy and sell orders.
How do you buy bonds?
You can buy bonds in three ways: individual bonds, bond ETFs and bond mutual funds. New issue bonds can be purchased through a broker or on secondary exchanges after issue. Bond ETFs and mutual funds can be purchased through a financial advisor or online brokerage.