What Are Bonds

Written by admin, last updated March 19, 2019

Trying to find the proper balance for your investment portfolio can be a most challenging undertaking. Depending on your stage in life and the amount of risk you are willing to assume, your portfolio may consist of equities, certificates of deposit, treasury bills, annuities, real estate or gold. These and a number of other investment choices may or may not be right for your personal situation. What are bonds? Today, we will take a look at the positive and negative aspects of owning bonds.

What are Bonds?

A bond is a debt instrument of one year or longer that promises to repay the full amount invested plus any interest that may accumulate up until maturity. The person holding the bond is a creditor and has priority over equity holders for payment in the event that the issuer files for bankruptcy or becomes insolvent.

Why is there a Need for Bonds?

Bonds are issued by different entities to fund projects that usually require a very substantial amount of money. Everyone from federal, city and local agencies to corporations and institutions may try to raise money by issuing bonds. Cities and towns often issue bonds to build and repair public works projects like parks, roads, bridges and mass transit transportation systems.

What is Par Value?

Par value is the price of the bond at maturity. It is also referred to as the face value. A corporate bond is issued with a par value of $1,000; a municipal bond is issued with a par value of $5,000 and a federal bond is issued with a par value of $10,000.

What is the Coupon Rate?

The rate of interest on a bond expressed as a percentage of the principal face value of the bond is called the coupon rate or coupon yield.

What is the Market Price of a Bond?

Bonds usually do not sell at par or face value. Instead, they sell at a market price that is a reflection of the current interest rate environment. There is an inverse relationship between bonds and interest rates. In a market where interest rates are higher than the coupon rate, a bond will sell below par or at a discount. Conversely, when the going interest rates are below the coupon rate, the bond sells at a premium to par.

What are the Different Types of Bonds?

There are several different types of bonds that an investor might consider when adding bonds to their portfolio. A federal bond is the safest type of bond as it is backed by the full faith of the United States Government. Interstate highways are one example where Federal bonds may be issued.

Municipal bonds are issued to raise money for states, cities, or other local forms of government to fund infrastructure projects like the public water supply or maintenance of city streets. They pay a lower interest rate than other forms of bonds, but they have the key advantage of being tax free.

Corporate Bonds

This type of bond usually pays the highest interest rate and it is issued by companies and corporations to raise money for their daily operations, expansion or other special projects. Corporate bonds are assessed for risk by the financial rating agencies. Those with the lowest risk can earn an A+ rating while companies with serious financial problems might have their bonds classified as “junk” or high risk status.

Investing in Bonds

There are a number of reasons why someone might invest in bonds. There can be tax advantages if you buy municipal bonds or, if you need a steady stream of income to live on you can set up a strategy known as laddering where you buy a series of bonds with different maturity dates that will allow you to receive steady monthly or quarterly payments. People who are risk adverse also can find bonds to be a more suitable investment with a guaranteed return if held to maturity.

Knowing what are bonds and how they should be used is very important for a well-balanced portfolio. Because bonds are a debt instrument and a promise to repay your principal with interest, they are considered a safer investment than equities. As the older a person gets, the general rule is that he or she should have a greater percentage of their total investment portfolio in bonds. A handy rule of thumb is to subtract your age from 100 and the number you come up with should be the amount you have in equities. As an example, a 70 year old should only have around 30{8e6cf663dd8bbfda1f4fdd38af84969e57c1756d87f56947f5c326d1d8b26fdc} of his or her money in equities and the remaining 70{8e6cf663dd8bbfda1f4fdd38af84969e57c1756d87f56947f5c326d1d8b26fdc} in more conservative bonds and other less risky investments.

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