The Basics – What are Bonds?

What are bonds? Bonds are essentially loans to a company or government, so that they can use this money to expand into new markets in the case of companies, or pay for public programs in terms of governments. Large organizations will often need to borrow significant sums of money, more than is usual to borrow from banks. Thus, bonds are used to raise money publicly, which allows for large numbers of investors to lend the money to the organization that issues the bond. The money that was used for buying the issued bonds (the principle) is paid back by the issuing organization to the investors by a fixed amount over a fixed number of years, often 10-30, and hence bonds are known as fixed-income securities. In addition to the principle being paid back, the issuer also makes interest payments to the investor, to entice the investor to make the loan.

Bond Investing Example. Let’s say you decide to buy a bond for $1000.00, which has a “coupon” of 8% and that “matures” in 10 years. What this means that you will be paid a total of $80 dollars a year from the interest of the bond (1000 loan x 8% coupon = $80). This $80 may be an annual installment or spread out over 2 or more payments. Then when the 10 years is up, the full $1000 is paid back to you.

Investopedia has a useful introductory video on what is a bond:

Bonds and Stocks are different. Bonds are debt instruments that have to be paid back by the issuer to the investor, while stocks are instead equity in the company, now allowing you to own a part of the company and share in either its profits and/or losses. Thus, in buying a bond, you become a creditor to the company, while in buying a stock you become a part-owner of the company (but with only limited liability). The big advantage of being a creditor is that your claim on the company assets is higher than stock holders, i.e. the bond holder gets paid first in case of bankruptcy. However the corresponding disadvantage is that the bondholder, who is a creditor, does not get any share of the profits made by the company.

Why buy bonds? Why would you want to buy bonds if you have only limited upside potential? Historically, stocks have performed better than bonds in the long term. However, due to the decreased risk, bonds are useful if you want to avoid shorter-term stock market volatility. Thus, bonds are often bought and held in or close to retirement, where a retiree can live off the fixed income without risking a large amount of money in the volatile stock market. Similarly, if you want to put aside a certain amount of investment money that you will use in the near term, within the next couple of years, then bonds may be useful in these short-term horizons to escape the market volatility, which can be quite significant.

Often financial advisors recommend weighting your portfolio heavily in stocks when you are young and far from retirement so that you can maximize gains. Then the common advice is to slowly increase the amount of bonds in your portfolio, as you come closer and closer to retirement, as you typically can’t risk exposing the majority of your portfolio to market volatility.

Investopedia also has an insightful video into the basics of bond investing:

As of 2014, I am generally not a huge fan of buying and holding bonds for the long-term, as interests are at historical lows. (Also, I am not close to the classical retirement age). This means that the fixed interest payments that you get when buying a bond now may well end up being below the rate of inflation that the odds/probability predict is likely to rise in the next couple of years. This means you will be loosing, rather than gaining money due to rising interest rates, unless you buy inflation protected bonds, such as TIPS whose interest payments rise with rising interest rates.