When you buy a bond, you are essentially loaning money to a bond issuer to fund their day-to-day operations or to finance specific projects. Consequently, bonds are sometimes referred to as debt securities. In return for your investments, bond holders get back the loan amount plus interest payments at regular intervals, based on a fixed annual rate (coupon rate).
During a bond’s term, you earn interest on your loan, which is the amount you invest to purchase the bond, just as you do on the money you deposit in a bank savings account. No one would buy a bond if the only incentive were getting back the money after a period of time. This is the bond issuer’s way of compensating you for its use of your money. The “income” in fixed-income investing is the interest you receive at a fixed rate, called the “coupon rate” or just the “coupon.” The rate at which the interest is paid is usually fixed when you buy the bond and stays the same for the term, the longer the maturity, the higher the coupon, and vice versa.
Smart investors do not put all their assets in one type of investment or “asset class.†The most common broad financial asset classes are stocks (or equity), bonds (fixed income) and cash. By spreading funds across a variety of different types of investments, diversified portfolios generally offer more reliable and stable returns over time. In order to figure out an appropriate mixture of these three, each individual must consider his or her own financial goals and tolerance for risk.
Bonds are considered less risky than stocks because bond prices have historically been more stable and because bond issuers promise to repay the debt to the bondholders at maturity. However, because bonds typically pay a fixed rate of interest, they are open to inflation risk: when interest rates rise, bond prices fall and vice versa. Also, there is a chance that the issuer will be unable to make its interest payments or to repay its bonds’ face value at maturity. This is known as credit or financial risk. When a bond issuer goes into bankruptcy, bondholders are paid off before stockholders.
Investing in bonds doesn’t have to be very challenging, the key thing is to know what the bonds are about before you commit. Many people want to see an immediate return on their money and if you are investing in bonds that just isn’t likely to happen. It should instead be viewed as a method of a stable income later in life. In fact, investing in bonds when young can garner a very healthy monthly income upon retirement
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