Bonds don't enjoy the same allure as stocks, but high quality bonds should be an essential part of your financial plan. Bonds promise a steady income stream, typically at a fixed coupon rate (interest rate).
What are bonds?
Bonds are debts that an entity (company, municipality, etc.) incurs in exchange for a sum of borrowed money. For example, a company might need funds to help finance its expansion. A city might need money to make needed repairs to its streets or municipal buildings.
Usually, the fastest way to raise the money needed is to sell bonds. In exchange for the money, the company or city promises to repay the debt at a fixed interest rate for a set period of time.
Advantages of investing in bonds:
Disadvantages of bonds:
- Bonds are predictable. You know how much interest you can expect to receive, how often you'll receive it, and when your principal (the bond's face value) will be repaid (maturity date).
- Bonds are more steady then stocks (which can fluctuate wildly short-term). Nervous investors usually sleep better by buying bonds instead of equity investments.
- People on a fixed income and/or in retirement will receive a predictable amount of regular income from bonds.
- The interest rates paid by bonds typically exceed those paid by banks on savings accounts, especially short-term bonds.
When should you buy bonds?
- Companies and municipalities can and do go bankrupt, and if they do, your bonds will lose value and possibly even become worthless.
- Long-term bonds will have your money tied up in low yielding bonds should interest rates go up.
- Unlike stocks, bonds don't offer the possibility of high long-term returns. Younger investors and those with several years to go until retirement would be better served by limiting their bond purchases and opting for equity buys instead.
- Bonds are a good option for those who need a steady and relatively dependable source of income, including the elderly and disabled. After retirement, bonds will provide a regular interest check to live on.
- As you progress from middle age and get within a few years of retirement, you should start gradually switching your assets from equity holdings (stocks) into bonds. As you get closer to retirement you want to reduce your investment risk.
- Many people buy bonds for reasons other than the investment potential. For example, the alumni of a university might buy the school's bonds to help out the old alma mater. And many people consider buying US Savings Bonds to be a patriotic duty.
If selected carefully and purchased at the right stages of your life, bonds can be a big help in reaching your financial goals as well as furthering the causes and organizations that are important to you.
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