In any general conversation about investments, you’re likely to hear stocks and bonds mentioned. Most people have at least a passing familiarity with the stock market, but what are bonds?
Here is a closer look at this common investment and how to determine whether it’s right for you.
What Are Bonds? The Basics of How Bonds Work
Cities, local governments and corporations often need upfront capital to fund projects. Sometimes, these entities choose to issue bonds instead of taking out loans.
When you purchase a bond, you’re effectively lending money to the bond issuer. The bond itself functions much like an IOU. In return for your investment, the issuer of the bond pays you regular interest.
You can usually cash in your bond at any time to recover your initial investment. However, if you hold the bond until it matures, you’ll get your initial investment capital back plus interest.
Bond maturities vary widely—some mature in just a few months, while others can take 30 years or longer.
Common Types of Bonds Explained
If you decide to invest in bonds, you have three main options to choose from:
- Municipal bonds
- Treasury bonds
- Corporate bonds
Here is a closer look at each type of bond.
Municipal Bonds
Municipal bonds—commonly called “munis”—are bonds issued by state, city and local governments.
Investing in municipal bonds can offer a way to generate returns while ensuring that your investment dollars benefit your local community.
Municipal bond interest rates and returns can vary, so it’s important to do your research before investing. For example, some municipal bonds based on revenue are “non-recourse” bonds. This means that if there is no longer enough revenue to pay interest, bondholders don’t have a way to recover their investment.
However, municipal bonds often come with tax advantages. In most cases, you don’t have to pay state taxes on bonds purchased from your home state.
Treasury Bonds
Because they’re backed by the U.S. government, Treasury bonds can be some of the best and safest bonds for long-term investment.
Treasury bonds generally pay interest every six months and mature in 20 or 30 years.
Corporate Bonds
Businesses issue corporate bonds. When weighing the pros and cons of government bonds versus corporate bonds, it’s important to understand that corporate bonds carry a higher default risk.
In other words, because the government doesn’t back corporate bonds, there’s a higher likelihood that you may not get your investment back.
In most cases, high-risk investments come with greater potential rewards. To make up for the increased risk, corporate bonds typically pay more in interest than government bonds.
When Should Someone Use Bonds?
Buying bonds can be a great way to diversify an investment portfolio. If you have any of the following investment goals, bonds could be worth considering:
You Want Predictable Returns
Bonds generally have a fixed interest rate and a set payment schedule. While the rate of return is often modest, bonds don’t carry nearly the same risk as stock market investments.
You Want to Preserve Your Initial Investment Capital
As long as you hold a bond until it reaches maturity, you’ll receive your entire initial investment back unless the issuer of the bond defaults.
You Want to Balance Out High-Risk Investments
When you’re building an investment portfolio, it can be a good idea to offset risky investments with stable ones.
For example, if you’ve already invested a significant amount in a highly volatile asset such as cryptocurrency, it might be wise to also invest some money in safer assets such as bonds.
Keep the Risks in Mind
As investments go, bonds are relatively stable. However, there are still potential risks to consider, such as the following:
Credit Risk
If the bond issuer fails to pay interest as agreed, you may not receive the return you were promised.
Interest Rate Fluctuations
When interest rates rise, the value of a bond falls. However, this will only become an issue if you want to sell your bond before it matures.
Otherwise, you’ll still receive interest payments as agreed upon and get your initial investment back after the bond matures.
Inflation
During periods of inflation, the purchasing power of the dollar decreases. This means that if your bond pays a fixed interest rate, inflation may effectively reduce the value of those payments.
Are Bonds a Good Investment if You Don’t Have Much to Invest?
Many people new to investing don’t have a lot of spare cash. So, how do you make money with bonds when you have limited funds?
If you want to purchase individual bonds, many issuers require a minimum investment of $1,000. However, if you choose a bond exchange-traded fund (ETF), you can invest as little as $100—or even less—while diversifying your investment across multiple bonds. Bond mutual funds work similarly.
Another easy way to dip your toes into the world of bond investments is to purchase savings bonds from the U.S. Treasury website for as little as $25.
Why Invest in Bonds?
Wondering “what are bonds?” Educating yourself about bonds is wise, whether you’re assessing bonds versus stocks or just want to get a solid grasp on how to make money with bonds before you start building a portfolio.
Understanding your goals and doing a little research can put you well on the way to formulating a successful investment strategy.