Last week we answered the question, “What is a Stock”. This week lets look at Bonds. You’ve heard of them, I’m sure as an investment, “stocks and bonds.” But what is it?
A bond is considered a “debt investment.” When you purchase a bond, you are loaning a company (issuer) your money. It’s the opposite of your mortgage or auto loan; you make money off of them. Though bonds rarely pay the same interest rate that you pay on your debt.
Because a bond is a loan, it pays a fixed interest rate (coupon), usually every 6 months, and after the loaned money is paid back (on the maturity date). Because they pay a fixed rate, they are also referred to as a type of fixed income security.
Also because the payment is fixed/predicable, they are considered a lower risk investment than stocks (we’ve all heard stories of people loosing money in stocks).
This lower risk comes at a price, though. Bonds rarely have the earning potential of stocks or mutual funds (we’ll learn about mutual funds in a future post), and as such, having any significant amount of them in a portfolio can limit your ability to grow it for retirement (this is contrary to most financial advisors’ recommendations).
The bond’s coupon is a function of credit quality of the company and the duration of the maturity. You’ve probably heard of “junk” or high-yield bonds; when you invest in those, you are loaning a company money that may not be around long enough to pay you back, and as such, they pay the highest rates, whereas companies such as GE pay very low rates.
It is possible to sell a bond before it’s maturity date; in fact, the first exchanges (think NYSE) were to buy/sell bonds! The Venetians were exchanging them as far back as the 1300s! In 1531 the first exchange was started in Antwerp, The Netherlands, long before stocks existed.
An interesting fact you may not have thought about is that Savings Bonds are debt instruments of the US Government. The national debt is nothing more than our government issuing bonds to pay for things that tax revenue doesn’t cover. If you want to read a little bit more on bonds and bond markets, check out Investopedia .
Well, what did you think of this article? Do you have any questions or comments? I’ll answer and address anything you post in the comments below: