Although people often mention stocks and bonds together, they are distinct. Unlike stocks, where you invest in a business and obtain a degree of ownership, bonds represent a loan you give to a business or government entity. In return, they promise to pay you a set interest rate. Bonds typically carry lower risks compared to stocks, but they also offer limited rewards. With bonds, you know your expected return upfront; you won't receive extra if the business or government exceeds earnings expectations. Here's what you should consider before investing in bonds.

Basics of Bonds

Bonds are often considered "safer" investments due to their reduced risks compared to other assets. Most businesses prioritize repaying their bonds as long as they remain financially stable. Therefore, a quarter with poor earnings for a company doesn't necessarily translate to a reduced return on your bond investment. However, this doesn't mean bonds carry no risk; it simply suggests lower risks than other types of investments. On the flip side, they may offer lower rewards. But, longer-term bonds typically offer higher yields to compensate for the increased risks associated with a longer time horizon.

Different Types of Bonds

When you're looking to buy bonds, you have several options. Some of the most common types of bonds include:

• Government Agency Bonds
• U.S. Treasury Bonds
• Municipal Bonds
• Corporate Bonds

Each bond type comes with its unique benefits and drawbacks. For example, while U.S. Treasury bond interest is taxable at the federal level, it's usually tax-exempt in most states. On the other hand, municipal bonds are exempt from both federal and state taxes. Due to their tax advantages, these bond types typically offer lower yields than most corporate bonds.

Understanding Bond Markets

The term "bond market" typically refers to the global exchange for debt securities. Unlike stocks, you can't trade bonds on the New York Stock Exchange. Instead, you usually buy or sell bonds through brokers or dealers in primary or secondary bond markets.

The Role of Bonds in an Investment Portfolio

Bonds can be an excellent addition to your investment portfolio for consistent income. Typically, bonds pay interest to investors semi-annually, so owning multiple bonds can produce regular income. Many investors view bonds as a "safer" investment, providing a cushion against riskier assets in their portfolios. While relying solely on bonds for retirement might not be advisable because of their lower returns, their relative stability makes them a valuable supplement to other investments throughout your retirement journey.

Bond Valuation

Several key factors influence a bond's value to investors. These include:

• Coupon rate: This represents the interest rate or set return the bondholder receives according to the bond's payment schedule.
• Maturity date: When the bond reaches its end term, the investor gets back the bond's total face value, which may differ from the initial investment or purchase price.

Various calculations come into play to determine a bond's potential value. Some brokerages use intricate methods to give their clients an advantage in the bond market. However, for potential investors, it's helpful to know that bond ratings indicate the risk level of specific bonds. For example, "below investment grade" rated bonds might offer attractive yields but have higher risks.

How to Buy/Sell Bonds

The good news is that it is relatively easy to purchase bonds today. Once only available through brokers, today's investors can purchase bonds through ETFs (exchange-traded funds), brokerages, or directly from the U.S. government. On the other hand, selling bonds requires that you work directly with a broker (you can use the same broker you used to purchase the bond initially), a bank, or a bond dealer.

Takeaways

Bonds can be risky investments, though many view them as safe, low-yield investments to round out portfolios, mitigate riskier investments, and generate income streams. Make wise choices when exploring your bond options; these are the perfect accompaniment to other investments you've made to further your long- and short-term financial goals.