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How bonds work

If you need money, you can get a loan from a financial institution. When governments or companies need to borrow a lot of money, they issue bonds. This gives them access to thousands of investors and allows them to raise very large sums of money.

A company needs funds to expand into new markets while governments need money for everything from infrastructure to social programs.

If you hold a bond, you have loaned money to an entity. In exchange for the loan, you receive interest. The interest rate and payment schedule are predetermined, as is the duration of the loan.

Bond vocabulary

  • The company or organization that sells a bond is known as the issuer.
  • The price paid for a bond is called the face value. It' is also known as the par value or principal.
  • The interest rate determined by the bond issuer is often referred to as the coupon.
  • The duration of the loan is called the maturity.
  • The interest rate is also called a coupon because sometimes there are physical coupons on the bond that you tear off and redeem for interest. This, however, was more common in the past. Nowadays records are more likely to be kept electronically.

Fixed income

Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back, provided you hold the security until maturity.

  • Bond face value: $1,000
  • Coupon: 8%
  • Maturity: 10 years
  • Annual interest payment for 10 years: $80 ($1,000 x 8%)
  • Reimbursement after 10 years: $1,000

Debt vs. equity

Bonds are debt whereas stocks are equity. This is the important distinction between the 2 securities.

By purchasing equity (stock), an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits.

By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). In the even of bankruptcy, a bondholder will get paid before a shareholder does. The bondholder, however, doesn't share in the profits if a company does well.

To sum it up, there's generally less risk in owning bonds compared to owning stocks, but this comes at the cost of a lower return.

Why bother with bonds?

Stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market.

Take 2 situations where this may be true:

  • Retirement. If you're retired, most of your assets should be invested in fixed-income securities because you simply can't afford to lose your principal. The income from it is required to pay the bills.
  • Shorter time horizon. If you want to go back to school in 3 years and your retirement fund is mostly in stocks, you should review your strategy. Because you can't risk losing the funds going toward your education, fixed-income securities are likely the best investment.

Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout your life.

For example, in your 20s and 30s, a majority of wealth should be in equities. In your 40s and 50s, the percentages shift out of stocks into bonds until retirement, when a majority should be in the form of fixed income.

Tools and tips

Characteristics of bonds

Learn about face value, coupons and default risk.

Read tip - Characteristics of bonds

Understanding bond yields

When a bond's price goes up, its yield goes down. The explanation.

Read tip - Understanding bond yields

Types of bonds

Discover the 3 main categories of bonds.

Read tip - Types of bonds

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