What is a Bond? The Investor's Loan
Learn how bonds work and the role they play in creating a stable investment strategy.
What is a Bond?
A bond is essentially a loan made by an investor to a borrower. The borrower can be a corporation or a government (like federal, state, or city governments). In return for the loan, the borrower promises to pay the investor periodic interest payments (called 'coupon payments') over a specified period and to repay the original amount of the loan (the 'principal') at a set date, known as the bond's maturity.
Bonds vs. Stocks
When you buy a stock, you become an owner in the company. When you buy a bond, you become a lender to the company or government. Bonds are generally considered less risky than stocks because bondholders are paid before stockholders if a company goes bankrupt.
How Do Bonds Work?
Imagine you buy a $1,000 bond with a 5% interest rate that matures in 10 years. The issuer will pay you 5% of $1,000, which is $50, every year for 10 years. At the end of the 10 years, they will give you your original $1,000 back.
The Role of Bonds in a Portfolio
Bonds are often used to provide stability and income to an investment portfolio. Because they are typically less volatile than stocks, they can help cushion the portfolio during stock market downturns. They provide a predictable stream of income through their interest payments.
Types of Bonds
There are many types of bonds, including: 1) Corporate Bonds: Issued by companies. 2) Municipal Bonds: Issued by states and cities (often tax-free). 3) Treasury Bonds: Issued by the U.S. federal government and considered very safe. The risk and interest rate of a bond depend on the financial stability of the issuer.