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Bonds are one of the most important investment asset classes, but they are also one of the most misunderstood. Bonds provide ongoing income to investors, and they tend to decrease portfolio volatility. As investors begin to construct their portfolios, it can be helpful to gain a deeper understanding of this important asset class.

What are bonds?

Bonds are debt instruments. When an investor buys a bond, they lend out a certain amount of money (called the principal value) to a company, a municipality, or government entities, or other individuals. The bond issuer (the entity taking on debt) agrees to pay the principal back plus interest (called the coupon value) on a certain date (called the maturity date).

Companies (or governments) with lower credit ratings must pay higher interest rates, and so must companies (or governments) that want maturity dates further in the future. This is to compensate the lender for the extra risk they are taking.

How do bond prices change?

Bond prices change inversely to the prevailing interest rate in the economy. This means that when interest rates fall, bond prices increase. On the other hand, when interest rates rise, bond prices decrease.

Typically when investors talk about the interest rate in the economy, they are referring to the interest rate that the Federal Reserve Bank of the United States pays on “risk-free” U.S. Treasury Securities (they are considered risk free since the United States has the best track record of paying back debt anywhere in the world).

When the Federal Reserve raises the interest rate that they pay on US Treasury Bills, prices on existing bonds fall. This is because any new debt will pay a higher interest rate than old debt. As a result the prices of existing bonds fall until the “effective discount” makes the bond interest rate in line with the new prevailing interest rate. Conversely, when the Federal Reserve lowers the interest rate that they pay, bond prices rise since new bonds will have a lower interest rate than older bonds.

Since all bonds are riskier than US Treasury Bills, all other bonds carry an interest rate higher than the rate for a US Treasury Bill. The specific interest rate for a particular bond is a function of supply and demand of debt combined with the risk of default and the length of time being borrowed. The risk of default on a bond is sometimes described using terms like investment grade bonds or junk grade bonds. Junk grade bonds simply indicates a higher probability of default whereas investment grade bonds have a lower risk of default.

How can I buy bonds?

Investors can buy bond funds or individual bonds using the same full service brokerage platforms that they use to purchase stocks. Bond funds are investment funds (like a mutual fund or an exchange traded fund) comprised of a variety of bonds with a variety of maturity dates.

Some bond funds specialize high quality bonds which tend to be very stable in price, whereas other funds will specialize in lower quality bonds which may be just as dynamic in price as stocks. Still other funds will focus on government, municipal or corporate bonds to the exclusion of other types of bonds.

Like with stocks, investors can attempt to find the highest yield bonds, but these will come with commensurately high risk ratings and potential for default. Rather than merely seeking out the highest yield bonds or bond funds, investors should seek to find bonds that fit with their portfolio goals. Since many investors use bonds to hedge against volatility, it makes the sense for these investors to seek high quality government or corporate bonds (or bond funds) with intermediate or longer durations.

How do bonds fit into your portfolio?

Learn more about bonds at wallstreetsurvivor.  They have a great guide to get you started and more.

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