Governments and businesses issue bonds to raise funds from investors. Bonds pay regular interest, and bond investors get the principal back on maturity. Credit-rating agencies rate bonds based on creditworthiness. Low-rated bonds must pay higher interest rates to compensate investors for taking on the higher risk. Corporate bonds are usually riskier than government bonds. U.S. Treasury bonds are considered risk-free investments.
Bonds offer safety of principal and periodic interest income, which is the product of the stated interest rate or coupon rate and the principal or face value of the bond. Bonds are ideal investments for retirees who depend on the interest income for their living expenses and who cannot afford to lose any of their savings. Bond prices sometimes benefit from safe-haven buying, which occurs when investors move funds from volatile stock markets to the relative safety of bonds.
You can buy bonds directly through your broker or indirectly through bond mutual funds. You can also buy U.S. Treasury bonds directly from the department's TreasuryDirect website.
The disadvantages of bonds include rising interest rates, market volatility and credit risk. Bond prices rise when rates fall and fall when rates rise. Your bond portfolio could suffer market price losses in a rising rate environment. Bond market volatility could affect the prices of individual bonds, regardless of the issuers' underlying fundamentals.
Credit risk means that issuers could default on their interest and principal repayment obligations if they run into cash-flow problems. Some bonds have call provisions, which give issuers the right to buy them back before maturity. Issuers are more likely to exercise their early-redemption rights when interest rates are falling, so you then might have to reinvest the principal at lower rates.
Municipal bonds are issued by states and local entities to finance construction projects and provide services. The advantages include higher interest rates than U.S. Treasuries, relatively low risk, and certain tax advantages. Municipal bonds are exempt from federal income tax and from state and local taxes if you are a resident of the issuing state.
But unlike Treasuries, these bonds are not risk-free. Some local governments have defaulted on their debt obligations because of slumping tax revenues.
Bonds vs. Stocks
Bonds are generally less volatile than stocks, but they underperform stocks over the long term. Younger investors might prefer stocks because of the potential capital gains. Investors nearing retirement might prefer bonds because they are more interested in preservation of capital and regular income.
- savings bonds image by Stephen VanHorn from Fotolia.com