A bond is a promise. When you buy a bond, an issuer promises to pay you interest on the money you have invested, along with the return of your investment at some future date. Governments, corporations, municipalities and other issuers sell bonds to raise money for various capital purposes, such as road building or plant expansion. Advantages for investors range from income and portfolio diversification to capital appreciation and inflation protection.
The primary investment reason to buy a bond is for the income. Most bonds come with a fixed interest rate, providing regular semi-annual payments to investors. This offers predictability of both cash flow and return, something that other investments, such as stocks, cannot offer. For example, if you buy a $1,000 bond that pays 5 percent interest, you will receive $25 twice per year for as long as you own the bond. You will also receive your $1,000 back at the end of the bond's life, known as the maturity date.
All investments have risks, but bonds are generally considered less risky than stocks. Few investments, stocks included, offer to pay your money back the way bonds do at maturity. However, this payback promise is only as good as the strength of the issuer. Outside ratings agencies assign letter grades to many bonds to help you determine their relative security. On most scales, a rating of AAA is assigned to the bonds most likely to make payments as promised.
Diversification is all about investing in different types of assets to lower the overall risk of your portfolio. Bonds play an important role in most asset allocation models, which divide investments among stocks, money market funds and other types of investments. Since bonds typically fluctuate in value less than stocks, they can smooth out the swings in your portfolio and dampen your overall risk. Generally, asset allocation models suggest that older or more conservative investors keep a higher percentage of their investments in money market funds or short-term bonds, as opposed to stocks.
While most bonds pay taxable interest, some bonds offer tax benefits. Bonds issued by municipalities are federally tax-free, and if you live in the state of issue, they are state tax-free as well. Interest on U.S. government securities, such as Treasury bonds, is free from state and local taxes.
Lower-rated bonds, also known as "high-yield" bonds, are seen as having a higher risk of default. Since higher risk translates to higher reward, most lower-rated bonds pay a higher interest rate to entice investors. High-yield bonds also have a greater potential for capital appreciation, as positive economic or corporate events can raise a bond's rating.
Most bonds carry inflation risk, which is the risk that the money you receive back at a bond's maturity isn't worth as much as when you originally invested. To combat inflation, the U.S. government issues I bonds, which raise their interest rate in line with rising inflation.
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