When you buy a stock, you become part owner of a company (equity ownership). When you buy a bond, you become a creditor of the company, not a corporate owner. When you invest in a bond, you are lending money to a corporation or government and their agencies, which are used to finance a project or put the money to work (working capital). In turn you are issued an I.O.U., a Promissory Note (a bond) obligating the issuer to:
Bonds, in general, are considered a safer investment than stocks, since you know the amount of "fixed income (interest)" you will be receiving and for how long. This does not mean that there is no risk with bonds, but the risk varies with the type of bond you purchase. You have some idea of how much risk you are assuming. Most bonds require a minimum investment—it can be $1,000 or $5,000. During difficult and uncertain economic times when the stock market might be depressed, investors tend to move their money into bonds. Bonds are also a good way to diversify your portfolio. Most investors have some money invested in bonds. And although you do not hear about it as often, the bond market is actually larger than the stock market.
- Pay back the principal, the amount they borrow, which is the amount of the bond, also known as Face Value.
- Give you a date, referred to as Maturity Date, when the bond issuer will pay back the principal amount borrowed from you. The date signals the end of the life of the bond. Some bond issuers reserve the right to repay the bond earlier than the maturity date, known as Calling.
- Pay you a fixed interest rate, also called Yield and Interest Payment, at specific intervals.
All bonds are not created equal. There are various types of bonds and they range from very safe—those issued by the U.S. Government such as Treasury Notes—to Junk Bonds, also known as high-yield bonds, which are issued, or have been issued, by companies in financial distress. These bonds pay higher interest, but they might not be able to pay the interest they committed to, or worse, they might not be able to pay the original bond amount. This only occurs when a company files for bankruptcy. Even if the company liquidates, a bondholder would likely receive some money, but only a portion of the bond they purchased.
Rating agencies, such as Moody’s, Standard & Poor’s and Fitch, assess bonds, and issue ratings or scores indicating how much of a risk investors take in purchasing a bond. Bonds with a low rating are at a higher rate of defaulting, and thereby must provide a higher fixed interest rate, to entice you to invest in the bonds. On the other hand, companies with an excellent rating will offer a smaller interest rate.
The value of the bond, or yield, can change over time. In general, as interest rates rise, bond prices fall; as interest rates fall, bond prices rise. The further away the bond’s maturity or call date is, the more its price will rise or fall in response to interest rates. This will be further explained below.
Bonds can be purchased individually or through mutual funds (where you are purchasing a portfolio of many different bonds which spreads your risk). Bonds are usually only one part of your diversified investment portfolio, which may include stocks, cash and sometimes precious metals.
To find out more about bonds go to http://www.investinginbonds.com and http://www.tomorrowsmoney.org.