Bonds can help diversify your portfolio, but they are not risk-free. Find out what a bond is, how bonds work and how they may work for you.
What is a bond?
Bonds are IOUs issued by corporations, federal, state and local governments and their agencies. When you buy a bond, you become a creditor of the corporation or government entity; it owes you the amount shown on the face of the bond (par value), plus interest.
In most cases, you won't receive the actual bond certificate. Bond ownership usually is in the form of a "book entry," meaning the issuer keeps a record of buyers' names but sends out no certificates. Treasury bonds, for instance, are issued in book entry form.
How do bonds work?
Typically, bonds that are lower risk pay lower interest rates; bonds that are riskier pay higher rates in exchange for giving up some safety.
Bonds are sold below par value, also known as face value. You get a fixed amount of interest on a regular schedule — monthly, quarterly, semiannually or annually — until the bond matures after a specified number of years, at which time you are paid the bond's face value. The interest rate is fixed at the time of the bond purchase.
Short-term bonds generally mature in three years or less. A bond that matures in three to ten years is called an intermediate-term bond. Long-term bonds typically mature in 20 to 40 years, although some are issued for shorter periods.
Three important facts to remember:
- Bond prices fall when interest rates go up — Bond prices and market interest rates generally move in opposite directions. When market interest rates rise, prices of fixed-rate bonds fall. This is known as interest rate risk.
- Bonds can be sold before maturity — After bonds are issued, they can be freely bought and sold by individuals and institutions in what's called the secondary market, which works something like a stock exchange. One exception — U.S. Savings bonds — can not be resold. However, they can be redeemed prior to maturity.)
- Bondholders get priority when a business fails — Bondholders own debt, not equity. If the issuer goes broke, you have first claim on the issuer's assets, ahead of stockholders. Some bonds are secured by liens on specific assets. If not, you are paid from the proceeds of liquidated assets.
Bottom line
When deciding whether to buy a bond, you should assess your risk tolerance and how long you want to keep the money invested. This will help you determine which bond will best serve you and satisfy your financial needs.
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