Looking for a safe haven for your cash? With so much uncertainty in the stock market right now, more Americans are jumping on the bond bandwagon. Here's a primer on the bond market. Realize not all bonds are risk-free.
What Is a Bond?
Bonds are I.O.U.s: debt instruments issued by corporations and the government to raise money via the public. After all you and I aren't the only ones who need to borrow money. Bonds are usually sold in increments of $1,000.
Are They Safe?
As a long-term investment, bonds carry less risk than stocks. In fact, on average, bonds attract the risk-averse -- investors who can't afford/don't have the stomach to place bets on individual stocks. Because of their relative security and safety as compared with stocks, bonds are often used as savings vehicles for down payments on a home, college education or retirement. The safest are generally government bonds, called treasuries, because they're issued by the Treasury Department. They include treasury notes, bills and bonds, which vary based on their maturities. Some experts call government bonds the "safest in the world," with the promise that you will be paid back by a certain date plus interest on the loan through installments. For example, as my colleague Taylor Smith explains on TheStreet.com, if you hold $1,000 in a 10-year Treasury bond with a 3.85% yield, the federal government promises to pay you back that principal investment of $1,000 in 10 years, and also to pay you $38.50 a year -- 3.85% of your principal -- in interest, or yield.
Corporate bonds are more risky because investors can lose their principal if a corporation defaults on a bond. The upside to corporate bonds is they usually pay more interest. More risk, more return. The best way to evaluate a company's bond is by referring to credit rating agencies like Moody's and Standard and Poor's, which rate bonds on a scale of AAA (the best) to "junk" status. Junk bonds are issued by struggling companies and carry high risks, and potentially high returns.
How Do I Buy Bonds?
As with stocks, you can buy bonds through brokers. Prices on more than 20,000 bonds are listed at www.nasd.com/trace. The government also has a Web site, www.treasurydirect.gov, that sells bonds online. When we buy bonds, we're essentially lending our money to the issuer with the promise of getting paid the "face value" of the bond when it expires, or matures. On top of that, we can assume getting paid fixed interest during the life of the bond, which can range anywhere from three months to 30 years. When you purchase a bond, all the conditions are laid out, including how much was lent, the interest and the term of the bond. These things are engraved in stone. A bond is essentially a pact with the issuer that they have to pay you or they go bankrupt. You can sell bonds, too, before they expire. But because bond prices fall when interest rates rise, so selling before maturity may come at a loss.
An Urban Dictionary for Bonds
Call provision: The stipulation that the issuer can call back the bond before it matures and pay it back with interest to date. This usually happens when interest rates fall and the company wants to issue new bonds with lower coupon rates.
Coupon rate: The regular interest promised by the issuer.
Face/par value: The face value of a bond or stock.
Maturity: Date when a bond expires.
Put provision: Stipulation that the bondholder has the right to "put" the bond back to the issuer before maturity. This usually occurs when interest rates have gone up and the bondholder wants to take on newer bonds that offer higher rates.