Bonds may seem unfamiliar to even some experienced investors but it can help you strengthen your portfolio’s risk-return profile. Adding bonds can create a more balanced portfolio by adding diversification and calming volatility. Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the bond market and the terminology. In reality, bonds are very simple debt instruments.
What are Bonds?
A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value. The company pays the interest at predetermined intervals, usually annually or semiannually, and returns the principal on the maturity date, ending the loan.
How is it different from Stocks?
Unlike stocks, bonds can vary significantly based on the terms of their indenture, a legal document outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important features to look for when considering a bond.
What are the types of Bonds?
Corporate Bonds
Corporate bonds refer to the debt securities that companies issue to pay their expenses and raise capital. The yield of these bonds depends on the creditworthiness of the company that issues them. Interest from corporate bonds is subject to both federal and local income taxes.
Sovereign Bonds
Sovereign bonds, or sovereign debt, are debt securities issued by national governments to defray their expenses. Because the issuing governments are very unlikely to default, these bonds typically have a very high credit rating and a relatively low yield. In the United States, bonds issued by the federal government are called Treasuries, while those issued by the United Kingdom are called gilts. Treasuries are exempt from state and local tax, although they are still subject to federal income tax.
Municipal Bonds
Municipal bonds, or munis, are bonds issued by local governments. Contrary to what the name suggests, this can refer to state and county debt, not just municipal debt. Municipal bond income is not subject to most taxes, making it an attractive investment for investors in higher tax brackets.
