When building an investment portfolio, there are three main investment types — stocks, bonds and mutual funds. Of these, bonds are typically viewed as more secure investments than stocks or mutual funds which typically offer a steadier income stream.
If you’re just getting started building an investment portfolio, here are some basics about bonds and why they can be beneficial to your investment portfolio.
What is a bond?
A bond is a fixed income investment where an investor loans money to an entity (buys a bond) for a defined period of time for a fixed interest rate. The owners of bonds are debtholders or creditors, of the issuer. Bonds are typically issued by companies or governmental agencies raising money to finance a variety of projects and activities.
Characteristics of a bond
There are five main components of bonds to be considered:
- Issue price. The price at which the bondholder purchases the bond. This can be less than the face value of the bond, which means the bond was purchased at a discount.
- Face value. Amount the bond will be worth at its maturity. This amount will vary depending on the bond.
- Coupon rate. The rate of interest the bond issuer will pay on the face value of the bond, always expressed as a percentage.
- Coupon dates. When the bond issuer will make interest payments. Typically, interest is paid twice a year.
- Maturity date. When the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
The coupon rate is determined by the credit quality of the issuer and the time until the bond matures. If the issuer has a poor credit rating, the risk of the issuer defaulting is higher. These bonds typically carry a higher coupon rate. Bond maturities can range from a day to more than 30 years. The longer the duration of the bond, the higher the coupon rate.
Bonds can be issued with one of two features, but may not have either one:
- Zero-coupon. These bonds don’t return regular interest payments. They sell at a discount equal to what the coupon rate would be on a similar bond.
- Convertible. A bond owner has the option to convert their debt into stock of the issuer if the stock price rises to a level desired by the investor.
While the return potential is not as great as with some other investments, bonds are an important part of any well-diversified portfolio. They can help offset some of the risk stocks and mutual funds create. The key to diversifying is managing your risk against potential reward. Talk to your financial advisor if you’re ready to get started investing with bonds.
The advice provided is for informational purposes only. Contact a financial advisor for additional guidance.