What Is a Bond?
A bond acts like a loan or an IOU that is issued by a corporation, municipality, or the U.S. government. The issuer promises to repay the full amount of the loan on a specific date and pay a specified rate of return for the use of the money to the investor at specific time intervals.
How Do Bonds Work?
When organizations want to raise money, they ask for a loan in the form of a bond, so when you buy a bond, you’re giving the organization part of that loan. In other words, once you purchase a bond, you become a lender. Then, the organization agrees to pay back the loan at face value on its maturity date. “Face value” indicates the full amount the bondholder (lender) bought the bond for. Additionally, bondholders will get paid interest periodically. Typically, bond interest rates are decided upon the risk of default. This means a bond with a longer term will require a higher interest rate to make it more attractive to buyers.
There are also benefits to investing in bonds, like the fact that they provide a stream of income to an investment portfolio. Bonds can help investors meet their income needs/goals, even if rates are low. Investing in bonds can also balance negative effects felt from market volatility if someone is invested heavily in stocks, since stocks are known to fluctuate more. Bonds are considered a more conservative investment vehicle, as the interest rate, face value, and maturity are set.
What Is a Bond Fund?
While bonds are individual securities, bond funds are portfolios of multiple individual securities or bonds. Typically, bond funds invest in and consist of fixed securities – these may include corporate and government bonds. These organizations might sell bonds to raise money to fund projects or operations. There are also bond mutual funds, which are mutual funds that consist mostly of bonds. After analyzing fixed income markets in the context of the bond mutual fund’s overarching goal, bond fund managers will purchase and sell bonds based on the market.
Stocks vs. Bonds
There are many differences between stocks and bonds that can help investors decide how heavily to invest in each. First, bonds tend to be less volatile since the interest rate, face value, and maturity date are set. Stocks, however, fluctuate and are less predictable – they must appreciate in value and be sold at a later date to make a profit. When you invest in bonds, you can expect the company to pay you back as long as it still has the resources to stay up-to-date on its loan payments. Second, investing in bonds does not give the investor any ownership rights, while investing in stocks grants partial ownership in a company. Therefore, stock investors can vote in company elections, which gives them some decision-making power. Finally, bond investors do not directly benefit from an organization’s growth. While stock investors do benefit from a growing company, people who invest in bonds won’t see much impact – this is also the case if the company is performing badly. In other words, bond investors will not get much indication on a company’s performance based on the bond.