Stocks vs. Bonds – Diversifying Your Portfolio:
Bonds are essentially debt obligations issued by governments and corporations in order to finance new projects. Governments, for example, issue bonds in order to fund the construction of new roads, schools, or other critical infrastructure. Corporations, for example, issue bonds in order to perform research, buy property & equipment, or grow their business in some way. The three main aspects of a bond are the face value, coupon rate, and maturity date. The face value is how much the bond will be worth at maturity, the coupon rate is the interest rate the issuer will pay, and the maturity date is when the issuer will repay the face value. For example, let’s say Greg buys a bond with a face value of $5,000, a coupon rate of 5%, and a maturity of 10 years. This means Greg is lending $5,000 to some government or corporation. In return, he will earn 5% on that $5,000 each year for the next 10 years ($5,000 x .05 = $250/year x 10 years = $2,500 total). At the end of those 10 years, the issuer will also repay Greg’s $5,000 initial investment.
The two most impactful determinants of a bond’s interest rate are credit quality of the issuer and time to maturity. Poor credit quality means higher likelihood of default by the issuer, so the interest payments to the bondholder will be higher. A longer maturity also correlates to higher interest rates since the bondholder is exposed to interest rate, inflation, and default risks for longer periods of time. While bonds are debt instruments based on interest rates, stocks are equity instruments based on company profitability and fluctuations in share price. In the event of bankruptcy, bondholders must be repaid in full prior to shareholders, making bonds lower risk investments. Bonds do, however, offer much less upside potential than stocks. No bonds are 100% risk-free, and there is always risk of default especially with corporate bonds, but U.S. National Government bonds have earned a reputation as being “virtually risk-free” investments. Overall, buyers of bonds (bondholders) are essentially lenders to issuers (governments and corporations) in order to fund new projects. Most bonds can be purchased by individuals through a brokerage, bank, or TreasuryDirect.
Related Post: What is Compound Interest? The Eighth Wonder of the World
