A bond is an I.O.U. from a company or government. When you “buy” a bond, you are loaning your money to the company or government for a set amount of time for a set interest rate.
Investopedia defines a bond as, “A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.”
Credit Quality and Duration Determine the Bond Interest Rate
Bond are given a grade on their ability to pay you back. This grade is their credit quality. Rating services like Standard & Poor’s and Moody’s give ratings on bonds. AAA and AA grades are high-quality bonds. BBB bonds are medium quality. It goes down from there. BB and below are considered “junk bonds”.
You may be able to get a higher interest rate with a lower quality bond, but you take a higher risk that the issuer of the bond may not be able to pay you back.
The longer term bonds also give a higher rate. Bond terms can be from 3 months to 30 years. The longer you are willing to loan your money the more interest you will get back.
Bonds are Considered Fixed Income
Bonds are often referred to as “fixed-income” investments. This is simply because they give you a set rate of interest for the term of the bond.
Bonds are between cash and stocks in terms of risk and reward. You can expect more return than you will get from a savings account, money market or CD, but you take on a little more risk with your principle. Bonds may not perform as well as Stocks but you will not have the dramatic down turns that stocks can have.
How Are Bonds Traded?
Like Stocks, bonds are usually traded through a broker. Most stock brokerage firms also sell bonds. After you buy a bond, you can sell it before maturity. This is also done through your broker.
Who Should Buy Bonds?
Bonds are typically used by those who want a more stable return on their investments. Most of the asset allocation schemes increase the bond portion of a portfolio as one gets closer to retirement.
In my inMessment Game portfolio I started out with a bond fund (I will discuss funds in another post). I may not keep that very long in my portfolio as I have a long time frame before I plan to “retire,” 20-25 years.
Here is a short video on Bonds from Investopedia: