What are Bonds and How Can They Benefit My Portfolio?
If you are new to the world of investing, you may be overwhelmed by the almost unending variety of products and asset classes available to you. A good place to start is understanding the basics of what these investments are and how they can work for you. Whether you are considering stocks, bonds, mutual funds, annuities, or even options, you want to arm yourself with knowledge before getting started. This article will focus on the popular income-oriented investment, bonds.
Bonds represent a loan or type of IOU to a corporation, pay a fixed rate of interest every six months, and have a maturity date at which time the bond’s face value (generally $1000 per bond) will be repaid to the bondholder. When a corporation needs to raise capital for expansion, one option they have is to sell bonds to investors. Bonds are an investment that may be of interest to investors seeking income. Their value is generally less volatile than that of other investments such as stocks or commodities. A bond’s value may be affected by different factors, primarily current interest rates.
Bonds may also have features the investor should be aware of before considering purchase. The first feature, and certainly most common, is a “call” feature. This allows the issuer of the bond to repay the bondholders before the bond’s stated maturity date. Issuers will “call” a bond if they are able to issue new debt at a lower interest rate and thereby save money. Bondholders that have their investments called before maturity are usually compensated by receiving a slight premium over the face value, perhaps an extra $20 to $30 per bond. The second feature a bond may have is the ability to be converted into the issuer’s common stock. Depending on the performance of the company’s stock, a convertible bond may equate to a potentially lucrative investment.
There are three main issuers of bonds: The United States Treasury, governments, both state and local, and corporations. Lets take a look at debt issued by the Treasury first.
Debt Issued by the United States
The Treasury of the United States issues what is considered to be among the safest debt as it is backed by the full faith and credit of the federal government. The Treasury actually issues debt that can be separated into three different groups depending on the maturity of each: bills, notes, and bonds. Treasury bills (T-Bills) mature within one year of being issued and can be a popular alternative to money market accounts and short-term certificates of deposit offered by banks. T-Bills do not pay interest; instead they are issued at a discount and mature at face value, the difference equating to the yield received. The second group of government debt is known as “notes”. Treasury notes have maturities ranging from 1 year to 10 years and are sold in denominations of $1,000. Notes pay interest to their holders every 6 months and mature at face value. The last category of Treasuries is bonds, or T-Bonds, have the longest maturity at 30 years. Treasury bonds also pay interest every six months. Bills, notes, and bonds all have very active secondary markets which makes Treasury debt a very liquid investment.
Cities and states can sell bonds to fund projects such as public utilities, building new schools or highways. These are called municipal bonds or “munis”. The distinguishing feature of municipals bonds is that the interest paid on them is exempt from federal taxes. This makes munis an attractive investment to income seekers in higher tax brackets.
Corporate bonds are debt issued by companies. Unlike shareholders, bondholders are creditors of a company and have no voting rights. They do however have preference, as bondholder’s interest will be paid before shareholder dividends.
Individual bond holdings can play an important part in an investor’s portfolio. Understanding the basics of individual asset classes you may be considering form the basis of a successful investment plan.