What are bonds?
Bonds are essentially IOU’s. A bond issuer, usually a government entity or a business, asks to borrow a certain amount of money for a certain period of time. If you agree to the terms, you collect the money you invested plus interest at maturity, or the agreed-upon time limit.
Bonds are an alternative investment to stocks. When you purchase a bond, in some ways you are acting as the bank for the issuer.
- Have less risk as an investment than stocks
- Have a fixed interest rate
- Have a maturity date
- Are issued by a variety of institutions, including the federal government, state governments, and city governments
Bonds are given grades to indicate their credit quality. For the most part, the higher the rating, the safer it is, but also the lower the interest. Ratings range from ‘AAA’ for high-grade bonds very likely to be repaid, to ‘D’ for ones that are currently in default.
While considered a “safer” option than stocks, there are also risks involved:
- Liquidity: An investment is considered “liquid” if you could find a buyer and you are able to get your money out of the investment quickly. U.S. Treasury Bonds and the Sovereign Bonds of other very large nations are the most liquid. On the other hand, illiquid ones often sell at a discount, so you must lower your price to find someone to take on the risk of such an investment. The lightly traded bonds of small nations and small corporations are among the most illiquid.
- Inflation: Occurs in the U.S. when the value of the dollar decreases and can purchase fewer goods and services than before. Inflation is bad for investors. If you purchase a bond with a 3.25% yield, but inflation rises at 4% at that same time, the money you get back is worth less than your original investment.
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Bonds vs Stocks
|Benefits from the growth of the company||Benefits from the interest paid for the loan|
These are issued by companies that seek to raise capital quickly or have low credit ratings. They are called “junk bonds” because of their higher risk in relation to investment-grade bonds. These are risky investments, but they can provide much higher returns. However, there is also risk with them in which the issuing company might default, and the investor will recover neither principal nor interest.