In the financial world, stocks tend to get most of the attention. But if you’re going to make progress toward your long-term goals, you need to be aware of all types of investments — and bonds can be an important part of your portfolio.
Many people, however, don’t fully understand how bonds work. So before you invest in them, familiarize yourself with the “bond basics.” Here are a few of them:
• Bonds are “debt” instruments. When you buy shares of stock, you’re actually becoming an owner — although one of a great many — of a company. But when you purchase bonds, you are, in effect, loaning money to whomever issues the bond — a business or the government. If you hold the bond until it matures, you’ll get your principal, or “par value,” back (provided the issuer doesn’t default) and, along the way, you’ll receive regular interest payments. A bond’s interest rate is known as the “coupon.”
• Bond prices will fluctuate. Your bond’s interest rate will not change over the life of the bond. However, bonds are subject to “interest rate risk,” which means that when interest rates rise, the prices of bonds can decrease, so if you sold your bond before it matured, you could lose some of the value of your principal. For example, suppose you own a $1,000 bond that pays a 4 percent interest rate. If new bonds are issued at 5 percent, no one will pay you the full $1,000 for your 4 percent bond, so if you wish to sell, you will have to offer it at a discount. Conversely, if market rates fall to 3 percent, your 4 percent bond will become highly desirable, so you could sell it for more than the $1,000 par value.
• Different bonds have different “ratings.” If you buy a corporate bond, you can choose between investment-grade bonds — those receiving the higher “grades” issued by rating agencies such as Moody’s and Standard & Poors — and “junk” bonds — those getting the lowest grades. Higher-quality bonds carry less risk of default but pay a lower interest rate than “junk” bonds, which must offer higher rates to attract investors who may be worried about default risk. Generally speaking, you’re probably better off by sticking with investment-grade bonds and staying away from the “junk.”
• Some bonds can be “called.” A callable bond is a bond that can be redeemed — or “called” — by the issuer before its maturity. If interest rates have declined since the bond was issued, companies can call bonds and reissue them at the lower, prevailing interest rate, thereby saving money on interest payments. As an investor, this could be cause for concern, because if your bond is called and you want to reinvest the proceeds in another bond, you’ll likely have to accept a lower coupon rate. Consequently, you may want to look for a bond that offers “call protection” — a guarantee that the bond can’t be called before a certain time.
To determine if bonds are appropriate for your individual situation — and, if so, what type of bonds — see your financial advisor. By adding bonds to your portfolio, you may well give yourself a broader platform for success.
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