When building an investment portfolio, most people focus on an asset allocation that includes to main types of assets: stocks and bonds. While we hear about stocks all the time (thanks to a financial media fixated on the Dow Jones Industrial Average), many of us don’t really hear much about bonds. However, bonds can be an interesting addition to your portfolio. They offer a certain degree of safety in some situations, and they can also provide a regular source of income.
Bonds are investments, though, so there is the possibility of loss. Your bond investments aren’t going to be insured by the FDIC, and you need to be aware of that. However, when carefully considered, bonds can make a solid addition to your investment plan.
Basically, bonds are loans. You loan your money to an organization for a set period of time. The organization uses the money to fund its operations, and pays you interest over the life of the loan. When the bond’s term ends, you receive your principal back. The reason that bonds are considered “less risky” than stocks and some other investments is due to the fact that you are supposed to receive your principal back. With stocks, you can lose your principal, but with bonds, even if something happens and you don’t receive your interest, you often recover some of your principal.
Of course, there is still the risk of default. An organization can choose not to pay what it owes. However, before things get to that point, you have still collected interest on the bond, so you don’t usually lose everything (although that’s certainly a possibility). Investing with bonds comes with its risks, but many agree that bonds represent one of the less risky asset classes. When you decide to invest, it’s important to remember that you can still lose out.
As you read about news on bonds, it’s important to keep in mind that prices and yields move inversely to each other. This means that when bond prices rise, yields are going down. When prices drop, yields head higher. Remember that the yield is the interest that you are paid. Also, keep in mind that a higher yield often means a greater risk. Organizations need to pay a higher yield in order to encourage investors to take on the greater risk of default.
There are different types of bonds, most of them classified according to the type of organization issuing them. Here are some of the main types of bonds that you are most likely to invest in:
You can purchase any bond, usually, with the help of a broker, online or offline, or from entities directly. It’s also possible to invest in bonds using index funds and ETFs.
You can learn about how likely an organization is to default by paying attention to ratings. Ratings agencies like Fitch and S&P rate bonds. The highest-rated bonds yield lower than other bonds with lower ratings. A bond that is rated AAA is considered less likely to be defaulted on than one that has a BB rating. While there are problems with the bond rating system, you can get an idea of how risky a bond might be.