Most investors are familiar with the two primary types of investments: stocks and bonds. Stocks are easy to understand because we hear about the stock market on a daily basis. The news constantly reminds us about whether the stock market is going up, down, and what companies are doing the best and worst. What about bonds? Most of us have bonds in our portfolios, but we hear very little about bond markets or how these financial instruments actually work.
You Become a Lender
When you buy a share of stock you buy a small piece of ownership of a corporation. The value of that stock fluctuates based on what investors, or the market as a whole feel the company is worth. A bond is quite different. When you buy a bond you’re not buying ownership of the company, but instead, you’re lending that company money. In return for your loan the company pays you interest. Think of it as a bank loaning you money, only the roles are reversed. When you borrow money from the bank the bank gives you a lump sum of money that you must repay over time with interest. That’s exactly how a bond works, but this time you’re the “bank” lending money to a company, which then repays you over time and with interest.
Types of Bonds
While the above example described a corporate bond, there are actually many different types of bond issuers. Not only can corporations issue bonds, but so can state, local, and federal governments. Have you heard of savings bonds? These are bonds issued by the U.S. government. The same principal applies and you lend money to the government while they agree to repay you with interest.
If you’re talking about local or state municipalities issuing bonds, these are typically referred to as municipal, or muni bonds. These bonds typically fund projects that either generate revenue or are needed for construction or maintenance. One of the benefits of municipal bonds is that if you purchase a local bond in your state of residence there may be special tax breaks on the interest earned.
How You Make Money With Bonds
Bonds are a little different than many other investments. With stocks, you’re looking for capital appreciation. This means you want the price of your stock to go up. When you buy a bond you’re not as concerned with the increase or decrease of the bond price, but primarily looking to generate regular income in the form of interest.
That’s not to say bond prices don’t fluctuate, because they can, but they typically remain much more stable than the share price of a stock. Because of this relative stability in price and regular interest payments, bonds are considered safer investments than stocks. This is especially true with government bonds which are backed by the full faith and credit of the U.S. government. In addition, some municipal bonds may even be insured.
Bonds are generally used by investors to offset some of the risk in their portfolio. Stocks can fluctuate from one day to the next by a significant margin, but bonds tend to remain fairly stable, and of course, pay out interest. So, by adding bonds to your portfolio you can mitigate some of the risk you’re taking in stocks by having some stable income from bonds.