A bond is a type of fixed-rate investment that governments and corporations issue to raise capital. A bond is a debt security, meaning that by purchasing the bond, the investor loans money to the issuer. Bonds have fixed interest rates and maturity dates. Interest is paid to the investor at the stated rate, usually every 6 months. On the maturity date, the issuer returns the bond’s purchase payment to the investor.
Types of Bonds
Bonds are most often classified by their issuer, with corporations and governments being the most common entities that issue them.
Bonds issued by the U.S. Treasury are generally considered risk-free and are the least risky types of bonds. Treasury bonds have a duration of more than 10 years. Shorter-term Treasury securities include bills (less than one year) and notes (between one and 10 years).
Aside from the Treasury, the U.S. government issues bonds through several other entities called agencies. Agency bonds are not considered risk-free because they are not backed by the full faith and credit of the U.S. government. They are, however, considered very high-quality securities and are rated higher than corporate bonds.
Many municipal governments issue bonds, and interest from these bonds is tax-free at the federal level. State and local governments can still tax this interest, though.
The creditworthiness of the issuer determines the quality of corporate bonds. These can be highly-rated or speculative in nature. Entities with low credit ratings issue high-yield bonds or “junk” bonds. They have higher interest rates than safer bonds in order to compensate the investor for the additional credit risk they carry.
As with any type of investment, bonds carry some risk.
The most prevalent type of risk in bond investing is credit risk. Credit risk is the risk that the issuer will fail to meet their obligations, resulting in missed interest payments or outright default. Rating agencies assign credit ratings to bonds, making easy to determine how risky a bond is.
Another type of risk is interest rate risk. Interest rates and the market value of existing bonds have an inverse relationship. As interest rates increase, the price of existing bonds decreases, and vice-versa. In general, shorter-term bonds are less susceptible to interest rate risk than longer-term bonds.
Understanding this is a key to knowing how changing interest rates will affect the portion of your portfolio that is allocated to bonds.
Bonds in Retirement Planning
Bonds are very popular retirement planning tools.
One attractive characteristic of bonds for retirement investors is that the value of bonds tends to be stable and less volatile than other investments such as stocks. For this reason, a common strategy is to increase bond holdings and decrease stock holdings as a way to de-risk a portfolio as retirement approaches.
The other benefit of bonds in retirement is probably obvious: the income. Bonds provide a stable stream of predictable income, with risk that can be managed according to the investor’s risk tolerance.