Normally, when you have an investment portfolio, it will include many things like stocks and bonds. Many guides and financial helpers will say that it’s better for you to build up your investment portfolio the older you get so you’re ready for retirement. Since bonds are included in this portfolio, many wonder what is a bond and why is it so important? Read below to see more details on what a bond is and how they work.
What is a Bond
With investments, bonds are usually included in your portfolio. A bond is a specific type of investment that will allow you to loan money to a borrower. Obviously, with all loans, it’s expected that you will get your money back with interest included when the term is over. Typically, you will be aware of the return you will be getting before you make a transaction, this is known as a fixed-income investment.
Using bonds is one of the options you have to put funds into a business or for your portfolio. They show that you have invested debt with a specific company that will have to pay back the money. This is considered an equity investment for stocks which means you own a portion of that company.
How Do They Work?
Purchasing a bond means you are allowing the person, company, or government that issued you the bond to borrow some money. In other words, because you are allowing your money to be borrowed, you’ll be earning interest with it as ell. After your bond reaches its maturity date, you’ll be given back the money you used to pay for the bond.
Typically, when you’re looking for bonds, compare the different prices, maturity dates, and coupon rates before you settle for anything. A coupon rate is the yearly money you get as a percentage of the principal that you’ve paid for your bond. Normally, these coupon rates surround the interest rate in the markets.
Bond Market
When purchasing a bond, you must be aware of the bond market and what its purpose is. Usually, a bond market keeps track of changes in interest rates made by the Federal Reserve and much more. The Federal Reserve can purchase and/or sell different treasury bonds that have an impact on interest rates, it’s also known as the federal funds rate.
Things that make interest rates increase is when there’s a shortage of cash, which makes borrowing money more expensive. An interest rate is the result of borrowing money and the Federal Reserve will be able to use a knock-on effect for other rates. Normally, when the interest rate is higher, the fee of a bond will decrease. In other words, higher interest rates result to new bonds to have a higher interest rate as well.
Purchasing Bonds
With Treasury bonds, you’ll be able to buy them straight from the US Treasury website. Buying other varieties of bonds such as: municipal and corporate bonds, you must go through brokerage. Normally, online brokerage will come with an additional fee for each trade you make.
Additionally, you’ll be able to purchase mutual bonds, bond ETFs, and bond index funds as well. A bond fund will allow you to keep different bonds while you look for better returns and more diversity. With a bond ETF, it will trade in the market and has tax advantages for mutual funds you can make use of. A bond index fund typically come with less pricier options since they are managed passively.
Risks of Bonds
There are many disadvantages and risks that come with purchasing a bond that you must be aware of. For example, an interest rate risk will change the interest rate and make your bonds less valuable. Usually, bonds come with different term periods, so the longer your term is the more risky it is for the interest rate. Another risk is having the price of your bond change if you sell it before it reaches it’s maturity date. Holding onto your bond will allow you to get your principal back, unless you aren’t able to pay it off.
Additionally, there’s another risk of purchasing bonds from a company or government that will give you the default bond. This will make you scrape for whatever the company has left in their assets. In other words, this is known as a credit risk. Another risk to be aware of is the inflation risk, if you purchase a bond that pays about 2% and inflation is 2.4%, you’ll be losing more money if you keep that bond. Not all bonds are good for investing into.
Conclusion
Overall, buying bonds is great for investing and allowing companies to borrow money. There are some perks included with getting a bond, especially if you’re nearing retirement. However, keep in mind that not all bonds are safe investing products. Bonds come with many risk factors you must know about before sealing the deal. Fortunately, when you search for a bond, comparing the different interest rates, and how they fluctuate will be helpful in getting a good long term bond.