In the financial world, stocks tend to get most of the attention. But if you’re going to make progress toward all your long-term goals, you need to be aware of all types of investments - and bonds can be an important part of your portfolio.
Many people, however, don’t fully understand how bonds work. So, before you invest in them, familiarize yourself with the "bond basics." Here are a few of them:
Bonds are "debt" instruments. When you buy shares of stock, you’re actually becoming an owner - although one of a great many - of a company. But when you purchase bonds, you are, in effect, loaning money to whomever issues the bond - a business or the government. If you hold the bond until it matures, you’ll get your principal, or "par value," back (provided the issuer doesn’t default) and, along the way, you’ll receive regular interest payments. A bond’s interest rate is known as the "coupon."
Bond prices will fluctuate. Your bond’s interest rate will not change over the life of the bond. However, the price of your bond can fluctuate, an important factor to keep in mind if you plan on selling your bond before it matures. A bond’s price will move in response to several variables, chief among which is interest rates Bond investments are subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease and the investor can lose principal value. For example, suppose you own a $1,000 bond that pays a 4 percent interest rate. If new bonds are issued at 5 percent, no one will pay you the full $1,000 for your 4 percent bond, so, if you wish to sell, you will have to offer it at a discount. Conversely, if market rates fall to 3 percent, your 4 percent bond will become highly desirable, so you could sell it for more than the $1,000 par value.
Different bonds have different "ratings." If you buy a corporate bond, you’ll have a choice between investment grade bonds - those receiving the higher "grades" issued by rating agencies, such as Moody’s or Standard & Poors - and "junk" bonds - those getting the lowest grades. The higher-quality bonds carry less risk of default but pay a lower interest rate than the "junk" bonds, which must offer the higher rates to attract investors who may be worried about default risk. Generally speaking, you’re probably better off by sticking with "investment grade" bonds and staying away from the "junk."
Some bonds can be "called." A callable bond is a bond that can be redeemed - or "called" - by the issue before its maturity. If interest rates have declined since the bond was originally issued, companies will call bonds and reissue them at the lower, prevailing interest rate, thereby saving money on interest payments. As an investor, this could be cause for concern, because if your bond is called, and you wanted to reinvest the proceeds in a new bond, you’d likely have to accept a lower coupon rate. Consequently, you may want to look for a bond that offers "call protection" - a promise that a bond can’t be called before a certain time.