This is Section/Lesson 3 covering Bonds. It's intended for someone who has had little if any investment experience. To start at the beginning, please go here. A glossary of investment terms is here.
Bonds are an excellent choice for those who need income; if your interest is only in growth, skip this section and go to the next section.
A bond is a loan you make to a company or government entity. When a company or a government (federal, state, county or local) needs funds, rather than going to a lender, it may instead decide to offer bonds. At regular intervals bonds will pay you interest, which is considerably greater than what you get elsewhere, and at the end of the bond period (the maturity date), typically 20-30 years, you can expect to get your money back in full.
No investments are risk free, but bonds are generally considered to be safer than stocks. Because of their stability, the rate of return is less than that of riskier investments. And because bonds generally have less volatility than stocks, a mix of stocks and bonds is often recommended to get decent returns with lower volatility, as shown in the figure (red line). Bonds from good companies were paying 4 - 8% in mid-2019 (for details, go here), considerably more than you get in a 5-year Certificate of Deposit insured by the U.S. government.
You typically buy bonds from other investors ready to sell theirs. And if you choose not to hold your bonds to maturity, you can sell them. I choose solid companies or governments, where the risk of default during the bond’s term is nil, and I tend to hold them to maturity. For diversity, if I have $50,000 to invest, I spread it out over, say, 10 companies rather than just 1. Here it’s best to deal with an investment firm which has expertise with bonds. Another approach is to buy a mutual fund which invests in bonds rather than stocks; I have little experience with these and even less advice to impart.
While bonds are typically less volatile than stocks, their price can fluctuate. If you buy a bond from a company or government which runs into trouble, a buyer will want to pay you less than what you paid for the bond. Similarly, if you bought a bond which paid 5% when you bought it, and you try to sell it when interest rates have gone up and comparable bonds are paying, say 8%, buyers will pay you less than what you paid for the bond. The inverse is also true, and buyers will pay you more if interest rates have gone down.
Although bonds are generally a safer investment, their value won’t grow. If you buy $100,000 worth of bonds today, when they mature 15, 20, 30 years from now, they’ll be worth $100,000 (the green line in the figure). Yes, you earned a nice income along the way, but 20 years from now those $100,000 won’t be worth as much because of inflation. So, if you want growth – the hope that $100,000 will become $200,000 in a few years – you buy stocks. For income, you buy bonds. For a balanced investment you buy both.
The interest from corporate bonds is taxable. For people in a high tax bracket, many/most municipal bonds (issued by cities, counties and states) have the advantage of not paying income tax. So a municipal bond paying 5% may represent closer to 8% for someone in a higher tax bracket. As with bond from companies, it’s important to select solid municipalities with strong finances. Even better, some bonds are also insured by solid insurance companies, so if a municipality defaults on a loan, the insurance company makes you whole.
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1 This was updated in Oct. 2019. The views expressed here are mine and at times may depart from the norm. In preparing this article I first read several articles, and ideas or phrases from those articles may have unintentionally crept into mine; I am happy to remove any plagiarism if alerted.