What is a bond?
In their simplest form, bonds are what companies and governments issue to borrow money. Thus, when you buy a bond, you’re really lending money to the issuer. In return, just as with any loan, you expect to be paid interest over time and to receive your principal (the original loan amount) back when the bond matures. The predictability of bonds is what makes them important sources of income for many investors.
There are many types of bonds, such as U.S. Government Treasury bonds backed by the U.S. government, corporate bonds, municipal (muni) bonds, and high-yield bonds, which are risky because companies may not be able to repay them. Each type of bond has its own unique characteristics that affect its attractiveness and appropriateness for different investors. For instance, the interest income from muni bonds is tax-exempt at the federal level and usually also at the state level, making them attractive for investors in higher tax brackets.
Different types of bonds have different levels of risk
A bond’s risk level is normally determined by the likelihood that the company or organization selling the bond is able to pay back investors their expected interest and initial principal. Based on their different levels of risk, bonds are assigned grades known as credit ratings. Investors use these as one way to identify safer bond investments versus riskier ones.
What affects the price of bonds?
There are many factors that affect the prices of bonds. These include the credit worthiness of the issuing company (the probability that the company can pay back the bond), prevailing interest rates in the market (generally as interest rates increase, bond prices go down), and several other characteristics. When interest rates rise quickly, bonds can decline in value because the interest they pay becomes less attractive.
Why an investment portfolio should include bonds
Bonds are fundamental building blocks of investment portfolios. This is because they can provide investors with increased safety in their portfolios, but offer lower growth potential in return (bond investors don’t participate in the growth of a company while stock investors do, for example). While bonds aren’t riskless, they are often less volatile in price than stocks. Thus, they can help to diversify investor portfolios and generate income.