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The Lexicon Series: Bonds

Last week, we reviewed the ins and outs of the stock market in an effort to break down some of the mysteries that surround owning shares of stock as an investment strategy. This week? Bonds.

Bonds can be a healthy piece of any diverse investment portfolio. They have a reputation for often being a more cautious investment that rarely fall prey to the highs and the lows that the stock market can be vulnerable to but they do carry their own kind of risk.

Here’s how they work. Bonds are loans or IOUs….except you are the one who is acting as the bank. If you invest in a Government bond, for instance, you are giving the government your money for them to use to accomplish their goals, (debt-reduction, infrastructure creation, etc.) and they are promising to pay you back with interest after an agreed upon amount of time has passed. When your bond reaches maturity, you cash out and receive the entire amount of the original investment back plus interest.

In fact, U.S. Government bonds are widely regarded as the “safest”* as they are backed by the “full faith and credit” of the U.S. Government. That said, there are lots of kinds of bonds that have varying degrees of risk associated with them. Examples include Municipal bonds (investing in a city,) and Corporate bonds (investing in a company). Cities don’t go bankrupt that often, so they too are relatively thoughtful investment. If you’re interested in investing in a Corporate bond, you may choose to exercise more caution as well. Corporate bonds can offer higher yields, but there may be more of a risk that a company could default on your loan (bond) to them. Before you invest in any bond, please review the bond’s credit rating and determine if the risk involved meets your comfort level.  Government and Corporate bonds all have different credit ratings.  Generally, the higher the rating, the lower the coupon or interest paid to you and vise versa.

Now then, here is the caveat. Bonds can be a strong investment but can carry a fair amount of risk especially with rising interest rates. That said, interest rates can affect their value. When you invest in a bond, an interest rate is assigned to the bond and a promise is made that, if you let the bond mature before cashing it out, you will receive the agreed-upon interest in addition to your original investment. That part won’t change.

However, when interest rates rise, your older bonds become less valuable. That’s because new bonds are issued at the new, higher interest rate, and instantly making old bonds less valuable than what is currently being sold on the market. That doesn’t mean that you will always lose money…it just means what you bought yesterday is less valuable than what you could buy today. The opposite is also true when interest rates lower, bond values tend to rise.

So! Now that you’re more knowledgeable to the nuances of bonds as an investment strategy, here are a handful of tips for you to keep in mind when dealing with bonds.