Bonds also may help partially offset the risk that comes with equity investing and often are recommended as part of a diversified portfolio. They can be used to accomplish a variety of investment objectives. Bonds hold opportunity – but, like all investments, they also carry risk.
These concepts are important to grasp whether you are investing in individual bonds or bond funds. The primary difference between these two ways of investing in bonds also is important to understand: When you invest in an individual bond and hold it to “maturity,” you won’t lose your principal unless the bond issuer defaults. When you invest in a bond fund, however, the value of your investment fluctuates daily – your principal is at risk.
What Is a Bond?
A bond is a loan to a corporation, government agency or other organization to be used for all sorts of things – build roads, buy property, improve schools, conduct research, open new factories and buy the latest technology.
Bonds operate very much like a home mortgages. The corporation or government agency that issues the bond is considered a borrower. Investors who buy those bonds, are considered the lenders.
Investors buy bonds because they will receive interest payments on the investment. The corporation or government agency that issues the bond signs a legal agreement to repay the loan and interest at a predetermined rate and schedule.
Bond Maturity Date
The bond issuer also agrees to repay you the original sum loaned at the bond’s maturity date. This is the date on which the principal amount of a bond – also known as the “par value” – is to be paid in full. A bond’s maturity usually is set when it is issued.
Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years. Whatever the duration of a bond, the borrower Kentucky pawn shops fulfills its debt obligation when the bond reaches its maturity date, and the final interest payment and the original sum you loaned (the principal) are paid to you.
Not all bonds reach maturity, even if you want them to. Callable bonds are common: they allow the issuer to retire a bond before it matures. Call provisions are outlined in the bond’s prospectus (or offering statement or circular) and the indenture – both are documents that explain a bond’s terms and conditions. While firms are not formally required to document all call provision terms on the customer’s confirmation statement, many do so.
You usually receive some call protection for a period of the bond’s life – for example, the first three years after the bond is issued. This means that the bond cannot be called before a specified date. After that, the bond’s issuer can redeem that bond on the pre-determined call date, or a bond may be continuously callable, meaning the issuer may redeem the bond at the specified price at any time during the call period.
Before you buy a bond, always check to see if the bond has a call provision, and consider how that might impact your portfolio investment.
A bond is a long-term investment. Bond purchases should be made in line with your financial goals and planning. Investing in bonds is one way to save for a downpayment on a home or save for a child’s college education.