In our last installment, "Basics of Investing - Part 1", we answered the questions: "Why Invest?", "What is Stock?", "What is the stock market?" and "What is the difference between saving and investing?". In this post, we will explain what a bond is and how bonds work.
Fundamentally, a bond is a loan to a company or government (city, state or federal). You are the lender, or "bond holder". The company or government agency is the "bond issuer". A bond typically has a fixed interest rate and a maturity date. If you hold the bond until the maturity date, you will be paid back the original loan amount plus interest. Some types of bonds pay regular interest payments during the period you hold the bond.
There are many types of bonds. Here are a few.
EE Savings Bonds are issued by the federal government and earn a fixed-rate of interest and can be redeemed after a year (though you lose three-months interest if you hold them less than five years). They can be held up to 30 years. They can be bought for any amount starting at $25.
Agency bonds are not quite as safe as Treasury issued bonds, but they are often safer than corporate bonds. They’re issued by government-sponsored companies. They are not backed by the “full faith and credit” of the U.S. government like Treasurys.
Municipal bonds, or Munis, as they’re commonly known, are issued by states, cities and local governments to fund various projects. Municipals aren’t subject to federal taxes, and if you live where the bonds are issued, they may also be exempt from state taxes. Some municipal bonds are more credit-worthy than others, though some munis are insured. If the issuer defaults, the insurance company will have to cover the tab.
Corporate bonds are bonds issued by companies. Corporate debt can range from extremely safe to super risky.
Most investment professionals agree that bonds help to dampen out the volatility of stocks and add a measure of protection against stock losses. Dave Ramsey disagrees. Here is a link to a very informative video clip wherein Dave explains why he does not advocate holding bonds. Virtually every other financial professional I follow online and 100% of the investors I have discussed this subject with has advocated some percentage of your portfolio be dedicated to some type of bonds. The list of people I have found to be at odds with Dave on this subject include Russ Carroll - Dave Ramsey's recently retired right hand man and one of the most knowledgeable financial people on the planet as far as I'm concerned. I discussed the subject of holding bonds with Russ personally at an investment training class he taught at Financial Peace Plaza years ago.
For further reading, here are some links to really good and in-depth bond explanations. Enjoy!
- Sound Mind Investing articles on bond investing. This is a list of very well-written and easy to understand articles. You can delve as deeply into the subject as you want at this site.
- Wall Street Journal personal finance pages - http://guides.wsj.com/personal-finance/investing/what-is-a-bond/
Next up, in our Basics of Investing - Part 3, we will explain what a Certificate of Deposit, or CD, is. See you then!
Jim
