As you hear about swings in the stock market, it’s normal to worry about your investments. After all, those hard-earned dollars are your life savings—and you aren’t keen on parting with them. That’s why diversifying your portfolio of investments is so important. Bonds are a key piece of that puzzle. Here’s a closer look at what they are, how to use them, and their benefits.
What are bonds?
Before learning about the benefits of investing in bonds, let’s talk about what they actually are. Bonds are like IOUs. When you buy one, you are lending money to the government, a local municipality, or a corporation. In exchange for your loan, the issuer agrees to pay you interest until it returns the full amount—also called its “maturity.”
You should keep in mind that no bond is 100% guaranteed, but you may notice that more risk may offer the potential for higher returns. One bond is not inherently “better” than another—it all depends on your individual risk tolerance and financial goals. Typically, you will see these types of bonds:
- U.S. Treasury bonds – The Department of Treasury issues these bonds for the federal government. Because they have the “full faith and credit” of the government, they are the safest type of bonds. The trade-off is you won’t earn as much interest.
- Agency bonds – Are you familiar with government-backed agencies like Fannie Mae and Freddie Mac? Those are the types of organizations that issue these bonds. For a little more risk, they may offer higher returns than U.S. Treasury bonds.
- Municipal bonds – States, counties, and cities issue these bonds and they are often called “munis.” They use the money to fund public projects like schools, hospitals, and roads. When it comes to risk, they fall somewhere between government and corporate bonds.
- Corporate bonds – Public and private corporations issue these bonds. They may be raising money for growth, capital improvements, or acquisitions. They are riskier than U.S. Treasury bonds, agency, and municipal bonds, but may offer higher returns.
- High yield bonds – These corporate bonds are your riskiest option. There is potential to earn the highest return, but it’s also possible the company may default on their promise.
Are bonds a good investment?
There are several benefits of investing in bonds. Before we dive in, it’s important to preface this by saying everyone’s situation is different. Your risk tolerance and financial goals are unique to you. Treat your portfolio accordingly. Some benefits of bonds may include:
- Diversification – At some point, you may have heard the phrase “don’t put all your eggs in one basket.” In a nutshell, that’s what diversification is. You are less likely to lose everything at once when you own different types of investments. The purpose is some protection against dips in the market. Diversification may be a savvy move, but it’s never a guarantee of returns or an exemption from losses.
Basic portfolios may include a mix of stocks, bonds, and cash. Stocks and bonds often behave differently, and depending on exactly which types you own, one may offset the other’s behavior.
- Income – If you are looking for a steady stream of income, bonds may be a good fit. Most bonds pay interest—or a coupon—twice a year. Depending on where you live and what type of bonds you buy, you may pay less taxes on your earnings, too.
- Protect principal – If you need to protect your buy-in, or “principal,” some less risky bonds may be a good move. When your bond reaches maturity, you will get your original investment back.
Are bonds a safe investment?
While bonds are generally considered “safer” than stocks, it’s not a rule that applies to all bonds. For example, corporate and high yield bonds aren’t exactly a safe bet. They may offer higher returns, but they are more likely to default on your interest payments or principal.
There are two ways to make money from bonds: 1) interest or coupon income, or 2) capital gains. If you sell a bond before it reaches its maturity, it may be worth more or less than the original price. If it’s worth more, you will have a capital gain. It’s also possible for the value to be lower, resulting in a capital loss.
One of the downsides of keeping bonds until maturity is you may miss out on higher interest rates. Depending on your return and inflation, it’s possible you won’t earn anything.
Do your homework before investing in bonds
While bonds may have a reputation for being “safer,” there is never a guarantee you won’t lose money. If decoding the world of stocks and bonds feels too overwhelming, ask for guidance. Investment advisors can help you invest based on your timeline and preferences.