Skip Navigation Links
 

Advantages

  • Generally, a predictable stream of income
  • Income typically higher than cash investments
  • Relatively lower risk compared to stocks
  • Low correlation with stock market

Tradeoffs

  • Risk of default
  • Bond values fluctuate with interest rates
  • Generally, lower potential returns compared to stocks
 

Types of Investments: Bonds

How do bonds work?

When you buy a bond, you're basically buying an IOU. Bonds, sometimes called fixed-income securities, are essentially loans to a corporation or governmental body. The borrower (the bond issuer) typically promises to pay the lender, or bondholder, regular interest payments until a certain date. At that point, the bond is said to have matured. When it reaches that maturity date, the full amount of the loan (the principal or face value) must be repaid.

A bond typically pays a stated interest rate called the coupon, a term that dates back to the days when a bondholder had to clip a coupon attached to the bond and mail it in to receive each interest payment. Most bonds pay interest on a fixed schedule, usually quarterly or semiannually, although some pay all interest at maturity along with the principal.

There are two fundamental ways that you can profit from owning bonds. The most obvious is the interest that bonds pay. However, you can also make money if you sell a bond for more than you paid for it. As with any security, bond prices move up and down in response to investor demand; they also are sensitive to changes in interest rates. If you sell a bond before its maturity date, you may get more than its face value, depending on how its interest rate compares to others. However, you could also receive less than the face value if you sell before maturity when bond prices are down.

The role of bonds in your portfolio

One of the most important reasons that investors choose bonds is for their steady and predictable stream of income through interest payments. Bonds have traditionally been important for retirees for this reason. Also, though they are not risk-free--for example, a bond issuer could default on a payment or even fail to repay the principal--bonds are considered somewhat less risky than stocks. In part, that's because a corporation must pay interest to bondholders before it pays dividends to its shareholders. Also, if it declares bankruptcy or dissolves, bondholders are first in line to be compensated.

Ways to Classify Bonds
By maturity
  • Long-term (10+ years)
  • Intermediate (1-10 years)
  • Short-term (less than 1 year)
By issuer
  • Corporate
  • Municipal
  • U.S. Treasury
  • Government-sponsored entities
  • Foreign corporations and governments
By quality
  • Investment grade
  • High yield ("junk")
By tax status
  • Tax-exempt: municipal bonds (generally exempt from federal tax)
  • Taxable: corporate, U.S. Treasury (exempt from most state and local tax)

The bond market often behaves very differently from stocks. For example, when stock prices are down, investors often prefer bonds because of their relative stability and interest payments. Also, when interest rates are high, bond returns can be attractive enough that investors decide not to assume the greater risk of stocks. Interest from bonds can help balance stock fluctuations and increase a portfolio's stability. And because a bond's face value gets repaid upon maturity, you can choose a bond that matures when you need the money.

Some bonds are exempt from federal or state and local income tax. This can be appealing to investors in high tax brackets.

Back

 

Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.