Bonds may not be as glamorous as stocks or commodities, but they are a significant component of most investment portfolios. Bonds are traded in huge volumes every day, but their full usefulness is often underappreciated and underestimated.
Why Invest In Bonds?
Bonds can help diversify your investment portfolio. Interest payments from bonds can act as a hedge against the relative volatility of stocks, real estate, or precious metals. Those interest payments also can provide you with a steady stream of income.
How Bonds Work
When you buy a bond, you are essentially loaning money to a bond issuer in need of cash to finance a venture or fund a program, such as a corporation or government agency. In return for your investment, you receive interest payments at regular intervals, usually based on a fixed annual rate (coupon rate). You are also paid the bond’s full face amount at its stated maturity date.
Bonds issued by private corporations vary in risk from typically super-steady utility bonds to highly volatile, high-interest junk bonds. Also, many corporate bonds are callable, meaning that the debt can be paid off by the issuing company and redeemed on a fixed date. The company pays back your principal along with accrued interest, plus an additional amount for calling the bond before maturity.
U.S. Government Securities
The securities backed by the full faith and credit of the U.S. government carry minimal risk. United States Treasury bills (T-bills) are issued for terms from a few days to 52 weeks. They are sold at a discount and are redeemed for their full face value at maturity. Other Treasury securities include Treasury notes, which have terms from 2 to 10 years, Treasury Inflation Protected Securities (TIPS), which have terms from 5 to 30 years, and Treasury bonds, which have a term of 30 years. Although the interest earned on these securities is subject to federal taxation, it is not subject to state or local taxes.
Various federal agencies also issue bonds. As with any investment, these bonds carry some risk. However, because the U.S. government guarantees timely payment of principal and interest on them, they are considered very safe. Some of these bonds use mortgages as collateral. Most mortgage-backed securities pay monthly interest to bondholders.