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How does investing in bonds differ from investing in stocks?
The corporation or government entity that issued the bond is borrowing from you, promising to pay you back at a certain date and to pay interest. You are taking the risk that you may not be paid back.
Generally, low-risk bonds pay lower interest rates than high-risk bonds. Bonds are rated using factors such as financial stability, current debt and growth potential. AAA ratings are the safest.
Although the interest rate payable under the bond may be fixed, bonds are traded on the market and bond prices rise and fall in value because of such factors as changes in interest rates or in the safety rating of the issuer.
Bond prices may be premium (more than face value) or discounted (less than face value).
Types of bonds
U.S. Treasury bonds are considered safe because they are backed by the U.S. government. Interest is exempt from state and local taxes, but not from federal tax.
Because the risk is low, the rate of return is relatively low as well, with longer-term bonds paying higher interest rates. There are many types of treasury bonds, including some that are protected against inflation.
Corporate bonds are issued by companies that are either publicly traded or private. Corporate bonds are riskier but pay more than Treasury bonds. Corporate bonds range from top-quality “investment-grade” bonds to risky “high-yield” or “junk” bonds.
Tax-exempt municipal bonds issued by state and local governments are exempt from federal income tax and, if you live in the state where the bond is issued, also may be exempt from state and/or local tax. The tax advantage makes the net return attractive to those in higher income-tax brackets.
A callable or redeemable bond is a bond that may be redeemed by the issuing company before the maturity date. If a high-yield bond is called, the investor will lose the high interest return for the remaining years of the bond.
Individual bonds versus bond mutual funds
You can purchase bonds through a broker, and Treasury bonds can be purchased directly from the government. An alternative to investing in individual bonds is to invest in a bond mutual fund managed by a professional.
However, there are some important differences. If you purchase a bond, you always get your interest and principal at maturity, so long as the issuer doesn’t go bankrupt. You also have control over when you realize capital gain from sale of the bond because you decide when to sell.
With a bond mutual fund, your return is uncertain. The fund will contain many different bonds that will be bought and sold as the fund manager sees fit. This means the amount of dividends you receive can vary and be unpredictable. Also, it is the fund manager’s decision to sell that triggers capital gains, which are then passed on to you during the year of the sale.
Are stocks or bonds better?
Sometimes bonds outperform stocks and sometimes stocks outperform bonds.
Bonds in general are safer than stocks if the issuer goes bankrupt because debt-holders get paid back from the assets ahead of shareholders. Generally, bond prices go up when interest rates go down and vice versa. Inflation erodes the value of bonds’ fixed interest payments. When determining the total return from a bond, consider not only the interest being paid but the rise and fall of the bond price.
Conventional wisdom holds that a certain percentage of your portfolio should be invested in bonds, the amount depending upon factors such as age, risk tolerance and need for an income stream from bonds paying a fixed rate of interest.