Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning money for a certain period of time to the issuer. In return, you get back the loan amount plus interest. Bond prices move in opposite direction of interest rates.
Important bond elements include:
Issuer, Interest rate (coupon rate), Call feature, Maturity date (short-term <1 year), Face value, and Rating (repayment ability).
There are many different types of bonds:
|Savings||Non-marketable security issued by US Treasury in small denominations for investors. Series EE and HH bonds. Low risk, low-interest rate of return|
|Treasuries||Direct obligations of the US Government. Includes treasury bills, notes and bonds. Interest income and Federal tax only.|
|Municipal||Debt issued by a state or local government. Interest income received is free from federal tax and is generally exempt from state and local tax if you live in the state the bond was issued.|
|Corporate||Debt issued by a corporation that pays interest semi-annually at a fixed rate and matures on a specific date.|
|Zero coupon||Provides no periodic interest payments. Bonds issued at fraction of face value and become worth their face value at maturity.|
|Junk (High yield)||High risk, high interest paying bond with a low bond rating due to the poor financial condition of issuing company. I don’t recommend these.|
Bonds have seen record buying in the past year or so from panicked investors. However, some investors like Warren Buffett are now saying that bonds are overvalued, expensive, and ready to “burst” much like the stock market did.
However, bonds do provide income and stability. As part of a diversified portfolio, you should own both stock and bond funds. That way, if the economy heats up and stocks jump in value, great. If bonds stay at low rates, that is okay because bonds are your safe money. If the economy tanks again, that is okay because you own some bonds to protect you from market declines. How much you allocate to stocks or bonds depend on your goals, risk aversion, and time horizon.