Maurie Backman: Hey, I’m Motley Fool contributor
Maurie Backman, and on this episode of FAQ, we’re walking through what bonds are and whether
or not they might be a good investment for you. When companies need to borrow money,
they can borrow it from banks or they can borrow it from regular people like you and me.
That’s where bonds come into play. Bonds are debt instruments issued by companies
as well as municipalities like cities, states, and counties. The U.S. government also
issues bonds, treasury bonds. When you buy bonds, you’re essentially agreeing
to lend the issuer a certain amount of money for a preset period of time. The issuer, in turn, agrees to pay you a certain
amount of interest over the life of your bonds, then return your principal investment
once the bonds mature or come due. Let’s imagine you buy $10,000 worth of
Company X’s bonds at 4% interest for a 10-year term, and you hold those bonds until maturity. That means you’ll collect two $200 interest
payments each year for a total of $400. Then, you’ll get your original
$10,000 back after a decade. But collecting interest isn’t the only way
you can make money from bonds. Bond values can fluctuate based on how the
market or a given issuer is doing. You might have the option to sell your bonds
above face value, or for a price that’s higher than what you paid for
them, and profit as a result. Now, some people like to lump bonds and stocks
into the same general investing category, but the two are very
different from one another. When you buy bonds, you’re lending the issuer
money, and it’s obligated to pay you interest and return your principal later on. When you buy stocks, you’re actually getting
an ownership stake in the issuing company. If that company then does well, it might share
its wealth in the form of dividends; you might also get voting rights that give you a say
as to how that company operates. With bonds, you get paid regardless of
whether the issuer is profitable, but you don’t get a say in how it manages its money. And, remember, some bonds are issued by the
government itself, and the government certainly doesn’t want your
opinion on how it should run. There are plenty of good
reasons to add bonds to your portfolio. First, though there’s no such thing as a risk-free
investment, they’re a relatively safe one compared to stocks because their
values don’t tend to fluctuate quite as rapidly. And, the better a job you do of vetting bond
issuers — which you can do by looking up their credit ratings — the less likely you
are to lose money on a bond investment. Bonds are also a good way to secure a steady
stream of income in the form of the semi-annual interest payments we talked about earlier. Stock dividends, by contrast, aren’t guaranteed
because corporations aren’t contractually obligated to pay them the same way
bond issuers are required to pay interest. Furthermore, usually, when you collect
dividends or interest, you’re required to pay taxes on that money. Some bonds, however, allow you
to earn interest without owing the IRS taxes. Municipal bonds, for example,
are always exempt from interest at the federal level. And if you buy municipal bonds issued by your
home state, you’ll avoid state and local taxes as well. Treasury bonds, meanwhile,
are always exempt from state and local taxes. On the other hand,
bonds do have their drawbacks. First, they require you to lock your money
away for a potentially lengthy period of time. If you’re the type who fears commitment,
you might have some issues with that. From a financial perspective, tying up your
money for what could be 10 years or more exposes you to something called interest rate risk. We just learned that bonds pay a certain amount
of interest depending on what their contracts call for. But what happens if you buy 10-year bonds
paying 4% interest, and a month later, that same issuer offers bonds at 4.5% interest? Suddenly your bonds lose value, and you lose
out on the added income that a higher interest rate would have given you. Furthermore, while bonds are considered safer
than stocks, they’ve historically delivered lower returns. If you load up too heavily on bonds,
you might limit your portfolio’s growth over time. Another thing you should know about bonds
is that they don’t trade publicly, so it’s harder to know whether
you’re buying them at the right price. While you’ve probably heard of the New York
Stock Exchange, a central bond exchange doesn’t exist. There is a group called the Financial Industry
Regulatory Authority, or FINRA, which regulates the bond market to some extent; but, bond
trading is still not as transparent as stock trading. Ultimately, if you’re going to buy bonds,
you might consider an approach called laddering. All that means is buying bonds that mature
at different intervals rather than sinking a bunch of cash into
bonds with a single maturity date. That way, you get access to your money along
the way, leaving you free to reinvest it in other places or snag higher bond
interest rates as they become available. Thanks for watching, guys! If you enjoyed
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