Bonds at their best are basically boring, which is probably a virtue!
Bonds are securities representing the debt of the issuer. You’re buying an IOU for which the issuer must pay the bondholder a specified rate of interest for a specific period of time and then repay the face value upon maturity.
You choose the duration of bond and also credit quality. Bonds are rated with the highest ranking, AAA or Aaa, given to issuers with the best credit and the lowest ranking, D, given to issuers who have defaulted on their loans.
The good news!
Some reasons why bonds are important choices for investors seeking income:
They offer a steady stream of income that will beat bank accounts or money market funds over the long term. Intermediate-term bonds maturing in five to seven years will hold onto the value of what you have.
They serve as protection for your portfolio against drops in the stock market. Two-to five-year Treasury bonds or two-year corporate bonds help reduce risk.
You can “ladder” a portfolio by buying bonds of different maturities, so you won’t be completely hammered by any market change.
But, on the other hand …
The downside is that bonds, once a bastion of dependability, have in recent years been ravaged by unpredictable interest rate jumps and plummets. Whenever interest rates go up, the value of existing bonds goes down.
Also, corporations and governments often will call in their older, high-interest bonds so they can finance at lower rates. You usually get five-to 10-year call protection, but, when a bond is called, you’ll receive just face value or a small premium. Goodbye, high return.
There’s more to be concerned about:
If you’re younger or middle-aged, stocks provide more growth potential than bonds. A new retiree shouldn’t put all of his money into long-term bonds with the goal of living off the income. Long-term bonds are highly volatile and probably won’t keep up with inflation.
What it costs?
There are several aspects of a bond’s value, making it more complex than most people realize:
There’s the principal, with the bond’s face value known as par. A bond selling at par is worth the same amount it will be redeemed for at maturity.
Most bonds pay interest semiannually, which is called the coupon.
The market price is what you can sell your bond for before its maturity. The current price depends on market conditions.
What’s most important is the total return, a combination of the annual interest and the bond’s gain or loss in market value.
The easiest bond transactions are for new issues, offered to the public by government bodies or corporations.
The issuer pays the broker’s commission. It’s a bit more pricey to buy older bonds sold on the secondary market, since there will be a dealer markup.
As with stocks, shop for the best deal!
If you don’t want to buy individual bonds, you can instead buy shares of a bond mutual fund, which is managed by a professional and pools money together from several investors to buy many types of bonds.