James, covalent, familial−bonds come in many different forms. But when it comes to your investment portfolio, those aren’t the kinds you’ll be interested in.
“What is a bond?” is something plenty of people wonder about. That was the fifth-most-asked finance question over the past year, according to data from Google.
In short, a bond is a loan. When you buy a bond, you’re giving your money to an organization with the expectation that you will be paid back at a future date, and that you’ll receive interest payments periodically. The payback amount, plus interest payments, is called "yield."
Organizations issue bonds as a way to raise money. For example, if a corporation needed to raise funds for a new project, it could issue bonds as a way to get the money up front and pay later. Likewise, if a city’s government needed money to build a new sports stadium, it could issue bonds to raise cash.
Generally, investors purchase bonds from businesses (corporate bonds) or the government (municipal bonds or Treasurys). You can also buy bonds indirectly, through shares of mutual funds or exchange-traded funds.
There are several types of bonds. These include municipal bonds, Treasurys, corporate bonds, foreign bonds, high-yield bonds, and more.
The values of bonds can fluctuate with the market and are susceptible to changes in interest rates. In that way, bonds are similar to stocks. But “stocks are infinitely easier to understand than bonds,” says Rick Kahler, a certified financial planner and founder of South Dakota-based Kahler Financial Group.
Bonds can and do trade on exchanges, like stocks, and are sometimes called “debt securities.” Also like stocks, they have inherent risks. The bond issuer could default, for example, and an investor could lose their money. Changing interest rates can also have an effect on a bond’s market value.
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Bonds don’t typically see fast or high rates of growth like stocks. Instead, they provide slow, steady, and low-risk streams of income through interest payments. For that reason, investors buy bonds in order to diversify or pad their portfolios with less risky securities.
In other words, an investment portfolio containing more bonds than stocks is going to be less risky, but there will also be smaller rewards. “Bonds will almost never give a return equal to equities,” says Kahler, who adds that investors generally buy bonds to give their portfolios a bit of shock resistance.
Bonds “help reduce volatility,” Kahler says. “So, assuming an investor can’t emotionally or financially stand sharp peaks and values of equities, they help reduce those peaks and valleys.”
If you want a way to make the stock market’s ups and downs a little more palatable, investing in bonds is one way to do it.