Bonds are fixed-income securities issued by governments and corporations. By buying a bond, you lend money to the bond issuer for a specified period of time. In turn, you get paid a fixed interest rate (the coupon) before maturity. Put simply the bond issuer agrees to pay you the coupon on or before maturity, and you get back the principal. Yet, if the bond issuer defaults, you lose your money.
Main Types of Bonds
Lending money to a national government is risk-free because theoretically, governments are not likely to default. Governments can print more money, which leads to higher inflation or they raise taxes to redeem the government bonds at maturity. Conversely, corporate bonds are riskier. If a company defaults, it won’t make timely payments on the bond principal. Typically, corporate bonds pay a higher coupon to attract investors, who are compensated for the higher risk of investing in a lower credit quality company.
Bond Pricing and Interest Rates
Investors like bonds because they provide a fixed return, which can be collected periodically during the year. Although stocks have higher returns than bonds, bonds have higher returns in the short-term because, in the long-term, the market interest rates may be higher than the coupon rate.
Bonds Are Not Risk-Free, After All
One of the risks of bond investing is inflation. For example, you buy a bond for a face value of $1,000, and you get $3,000 after five years. If the inflation rate is stable during the investment period, the actual value of your bond is $3,000. However, if the inflation rate has risen from 2.5% to 4%, the actual value of your bond is lower than $1,000. Conversely, if the inflation rate has fallen from 2.5% to 1.5%, the actual value of your bond is higher than $1,000.
Moreover, foreign bonds incur currency risk. For example, you buy a US Treasury for $1,000 at an exchange rate of USD/GBP 0.75, and during the investment period, the value of the USD falls against the GBP. You will face GBP losses at maturity.
In conclusion, bonds can diversify your portfolio with an element of stability. So, if you are for a steady stream of income without undertaking a high risk, bonds are a safe investment. Just keep in mind that low risk does not mean risk-free.
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