From stocks and cash equivalents to real estate, there are many types of asset classes. Another common one is bonds.
Surprisingly, many investors don’t take advantage of bonds. They don’t understand how this asset class works, let alone how it can help them optimize their investment portfolio.
Read on for everything you need to know about bonds. We’ll go over key terminology, the different types you can purchase, and more.
Let’s start with the basic definition of a bond. Under the terms of a certificate, the holder loans money to the issuer. The issuer promises to pay periodic interest payments to the holder. At the end of the maturity period, the issue must return the principal amount to the holder.
Like any investment, these loans come with risk. It’s possible that if the issuer defaults on the loan, your bond becomes less valuable due to rising interest rates, etc.
However, generally speaking, bonds are safer than other kinds of investments, such as stocks, as the issuer has a legal obligation to fulfill the terms on the certificate.
Now, let’s go over some other key terminology:
Face value, AKA par value, is the principal amount that the issuer must return to the holder at the end of the maturity period.
The coupon rate is the annual rate the issuer must pay. For instance, say a ten-year, $1,000 bond has a coupon rate of 5%. The issuer will pay the holder $50 every year for ten years. At the end of the maturity period, the holder will have $500 plus the initial face value of $1,000.
Note that the percentage is based on the face value rather than how much you bought the certificate for. So, if you buy a $1,000 certificate with a 5% coupon rate for $1,500, you will still get $50 every year (not $75).
Independent rating agencies issue credit ratings to indicate how risky a loan is. The ratings can be helpful, but you shouldn’t trust them wholeheartedly. Always compare ratings from several agencies and do your own research before investing.
When certificates trade above their face value, they’re trading at a premium. So, if you buy a $1,000 certificate for $1,500, you are trading at a $500 premium.
A discount is the opposite of a premium. If you buy a $1,000 certificate for $800, you’re trading at a $200 discount.
What are the Types of Bonds?
There are many types of bonds. Below, we categorize them based on the issuer:
Central treasuries issue loans to raise money for government spending. Because the federal government is the issuer, these investments tend to carry the lowest risk. In most cases, they come with lower coupon rates.
When local governments need to fund public improvement projects, they’ll issue municipal loans. They are of medium risk, have average coupon rates, and pay interest that’s mostly exempt from government taxes.
Corporate loans are by far the riskiest type, but they come with higher coupon rates.
What is Bond EFT Exchange Traded Funds?
Throughout this guide, we’ve focused on buying individual bonds. However, you should also be aware of bond ETF. They don’t promise periodic interest payments or return of the principal investment. However, they have lower initial buy-ins and offer more diversification.
Conclusions — Safe Investments For Diversifying Your Portfolio
Investors should not overlook the value of bonds. They are a great way to put your money to work as they guarantee periodic income and diversify your portfolio.
When you go to buy certificates, it’s important to do your research. Review credit ratings to determine which type (federal, municipal, or corporate) is best for your finances.