Does financial jargon seem confusing to you? If you listen to any financial media, you may find yourself lost in a sea of words of which you have no concept of their meaning. And even if you do have an understanding of basic terms, there may still be some information you’re missing.
A bond may be one of the common terms you think you understand, but are you sure? Here’s a deeper look into the investment so you have a better working knowledge.
A bond is essentially an ‘IOU,’ or a debt obligation. Governments and corporations need funding for one reason or another (such as railroads, infrastructures, or for the expansion of their company), so they issue a bond that they can pay back over time.
As the investor, you give that government/municipality/corporation an amount of money for a set period of time, then that entity pays you regular payments at an agreed upon interest rate. If the entity is still solvent by the time your bond ‘matures,’ you then get your initial investment back.
One of the benefits of a bond is that it can generate a consistent stream of income for an investor. They’re often considered as part of the ‘conservative’ percentage of your investment mix, helping to balance out the volatility of stocks.
Depending on your risk tolerance, a trusted financial planner (we recommend a CERTIFIED FINANCIAL PLANNERTM or a Charted Financial Consultant®) can help you select the best investment mix to reach your financial goals.
They still have risks
However, this doesn’t mean bonds don’t come with their own set of risks.
For instance, what’s the credit-worthiness of who you’re lending your money to? The riskier the entity, the higher interest rate it will have to pay to attract investors.
Some of the riskiest bonds are called high-yield bonds (AKA, ‘junk bonds’). The bonds with the best histories for repayment are called investment-grade bonds. Note: the safest bonds are usually issued by the U.S. government (Treasury bonds) since the government has the power to tax citizens to pay the bondholders.
Also, consider the length of time you hold your bond. The longer your money is held up, the higher the interest rate will be. You’re essentially being paid for keeping your money tied up with the loan. For example, you would receive a higher interest rate for a 10-year bond, vs a 1-year bond.
Lastly, interest rates can also affect bonds due to their ‘inverse’ relationship. This means, when one goes up, the other goes down – like a teeter-totter. Long-term interest rates and short-term interest rates can impact bonds differently.
Here are some other bond terms you may want to know:
Savings bonds can be used as gifts. You can redeem your savings bonds after holding them for a certain period of time, with 30 years as the maximum. There are two types of savings bonds and both are issued from the U.S. Treasury.
Municipal bonds are often referred to as ‘Munis.’ They’re issued by states, cities, and local governments to fund various projects. Munis are most commonly insured, however, if the issuer falls through, the insurance company will have to make up the payments. They can also be exempt from state taxes and aren’t subject to federal taxes.
Corporate bonds are issued by large companies. This type of bond can range in risk exposure depending on the credit-worthiness of each company.
Coupon is the annual interest rate on the bond. For an example, if your bond value was $1,000 and had an interest rate of 5%, your coupon would pay $50 per year.
Duration is a measure of the bond price variation in association to the change in interest rates depending on the number of years. Bonds with shorter durations are less sensitive than bonds with longer durations.
The Simply Money Point
Simply Money Advisors believes bonds should continue to be an important part of any well-diversified investment mix. Bonds can be ‘shock absorbers’ when the stock market gets a little turbulent.