For investors who do not want to take on the risky nature of stocks, bonds provide a good alternative. While stocks are volatile, bonds provide a fixed, steady income stream; however, this also means that you’ve got no chance of accumulating massive amounts of cash in a short time, which is possible with stocks.
Basically, a bond is loan borrowed by a supranational agency (e.g. the Asian Development Bank), a national government (e.g. the US Government), a state, a municipality, or a large company. Who’s the lender? You, the investor, who is guaranteed a payment of the original investment plus interest (called the coupon). Most bonds are issued for a fixed term (called the maturity), which is usually longer than one year. This definite lifespan is an important difference between bonds and stocks, as stocks may be held indefinitely.
To finance their activities, companies can raise money either by issuing stocks or by borrowing it from another entity (debt financing). They can accomplish the latter case by borrowing from a bank or issuing bonds.
U.S. Government bonds are called treasuries, which are the safest bond investments around. They can be either treasury bills (maturity: 90 days to one year), treasury notes (2 to 10 years), and treasury bonds (10 to 30 years). On the other hand, corporate bonds can come in short term maturity (1-5 years), intermediate term (5-15 years), and long term (longer than 15 years).
As mentioned earlier, bondholders receive a fixed, steady income stream. The income is generated by the interest/coupon rate on the bond, which is a percentage of the bond’s original price. Bond maturity is achieved when the bond expires and the original investment is paid out to the bondholder.
Even though investing in bonds is less risky than investing in stocks, you should heed the following caveats:
- Bonds, once you obtain them, are not as easy to sell as stocks.
- Bond prices ebb and flow with the market value – it is entirely possible for you to lose money if the bond’s principal value decreases.
- A rising inflation rate spells doom for your bonds. With inflation, the worth of your investment today is less than its worth tomorrow.
- A good economy poses a threat to your bonds, as consumer prices are bound to rise. This is related to inflation.
- Some bonds are callable – if you don't want one, watch out! Callable bonds can be paid off by the company early, forcing you to take your money somewhere else, thus creating reinvestment risk.