Bonds — Being a lender can create interest


If you have a mortgage, are making car payments or have ever used a credit card, you know what a loan is. You borrow money and agree to pay it back at a specific interest rate over a certain period of time. It can be a convenient way to spread out the payments for large purchases.

How bonds work

Investment bonds are loans. The borrowers (those issuing the bonds) can be corporations, or local, state or federal government agencies. The lenders (those providing the money) are investors like you. When you buy a bond, or a bond mutual fund, you are lending out your money to a company or entity that needs capital. In return, the bond issuers promise to pay fixed interest payments. At the end of the loan period (called the maturity date) the original loan amount (the principal) will be repaid.

Bonds may help provide stability to a stock portfolio.

A look at the risks

A bond’s risk mostly centers around how likely it is that the bond issuer will fail to keep its promise to repay the loan and the interest. This is called credit risk. The federal government has never defaulted on its bonds, so their bonds have very low risk. A corporation, on the other hand, has the potential to go bankrupt and default on its bonds, so corporate bonds generally have higher levels of risk. As with all investments, the lower the risk, the lower the potential returns.

Rating agencies measure the quality and safety of bonds. Bonds are generally classified as either investment grade (higher quality) or “junk” (lower quality). Check the ratings before you invest so you can manage your risk level.

Types of bonds

Here are four common types of bonds:.

  • U.S. treasuries — Interest and principal payments are guaranteed by the U.S. government, so treasuries have the lowest risk but also the lowest potential returns.
  • Municipal bonds — Issued by state and local governments and their agencies. These are typically used to fund public works projects. Interest payments are exempt from federal taxes and, in many cases, state and local taxes too.
  • Mortgage-backed securities — Packages of mortgage loans issued or guaranteed by government agencies such as Freddie Mac and Fannie Mae. Risks are generally higher than with Treasury bonds.
  • Corporate bonds — Issued by corporations as a way to raise money for business operations. Their worth depends on the creditworthiness of the company issuing them. They may carry higher risks and potentially higher returns.

Use bonds to help with diversification

The steady income payments from bonds help to provide a stabilizing component to a stock portfolio. Typically, the bond market and the stock market have an inverse relationship. That means when one is down the other may be up. Diversifying across different types of bonds along with stocks can help to reduce volatility in your portfolio.