Mutual funds are an easy way to begin investing because they're straightforward. You can buy shares in a fund at any time and you can sell them at any time, provided you're willing to pay the associated fees. Investing directly in stocks and bonds is more complicated, especially with bonds. They're issued with a specific maturity date, and most kinds can't be directly cashed out when you want.
Bonds and Liquidity
At its most fundamental level, a bond is simply an IOU. You loan your money to a company or a government for a specific period of time. In exchange, they pay you a specified amount of interest at the end of that time. Letting you take back your money by cashing out the bond defeats the whole purpose, and most bond issues won't let you do it. That ability to move your money in and out of an investment is called liquidity, and liquidity isn't built into most bonds. The notable exception is government savings bonds.
The Treasury's I and E series savings bonds are sold with 30-year maturity dates, which is an awfully long time to tie up your money. However, they're intended as a savings product rather than an investment product. They pay modest interest rates, but the rates are higher than most bank accounts. In exchange for this inexpensive use of your money, they'll allow you to redeem or cash out the bonds as needed after the first five years. During those five years they'll charge a penalty for withdrawal, which usually makes cashing them a losing proposition.
The Secondary Market
That doesn't mean you're stuck with your existing bonds. You can trade them on the secondary market, where bonds are bought and sold by speculators. Bonds rise and fall with fluctuations in the interest rates, or because investors are stampeding from stocks during a downturn. If your bond pays 7 percent and rates drop to 5 percent, your bond's high rate makes it more valuable than new bonds, and its price goes up. When rates go up, the opposite is true. In real life other factors are important, including the credit-worthiness of the issuer and the bond's callability.
Callability means the issuer can call in your bonds before their maturity date, and give you a reduced payout. In other words you can't cash them out, but the issuer can. This usually happens when rates are dropping, because that reduces the cost of borrowing for the issuer. They can call in the old high-rate bonds, issuing new ones at the lower current rates. Callable bonds usually pay slightly higher interest, to compensate you for that risk, and guarantee you an initial period when they won't be called. If you own bonds, ask your broker whether they're callable and what your yield will be if they're called in.
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