Q. What's a bond?
A. Nothing more than an IOU. If a company issues bonds, it's borrowing cash and promising to pay it back at a certain rate of interest.
Bonds sold by the U.S. government's Treasury Department are called "Treasuries." State and local governments issue "municipal bonds," while businesses issue "corporate bonds." Companies that may be perceived as low-quality are forced to offer high-interest-rate "junk" bonds to attract buyers. There's a higher risk that someday they won't have the cash to cover interest payments and the bonds will default.
Bond investors receive regular interest payments from the issuer at what is called the "coupon rate." For example, a $1,000 bond with a coupon rate of 10% generates payments of $100 per year. When the bond matures -- after perhaps five, 10, or 30 years -- investors get back their initial loan.
Sometimes a company will "call" its bond, paying back the principal early. All bonds specify whether and how soon they can be called. Federal government bonds, traditionally, were never called, although that may be changing. A 30-year bond was recently called.
To calculate a bond's yield, divide the amount of interest it will pay over the course of a year by its current price. If a $1,000 bond pays $75 a year in interest, its current yield is $75 divided by $1,000, or 7.5%.
Once issued, bonds can be traded among investors, with their prices rising and falling in reaction to changing interest rates. For example, when rates fall, people bid up bond prices. If banks are offering 6%, an 8% bond starts looking good. Bond prices also react to supply and demand, and the fortunes of the issuers. (Just ask anyone who owns bonds from Enron.)
In the long run, stocks have outperformed bonds handily. According to Jeremy Siegel's Stocks for the Long Run, from 1802 to 1997 (yes, you read that right -- 195 years), the stock market offered an average nominal annual return of 8.4% per year, compared to 4.8% for long-term government bonds.
Stocks outperform bonds even when you eliminate the 19th century data. According to Ibbotson & Associates, from 1926 to 2000 (notice that includes the Great Depression), U.S. Treasury bills returned an average of 3.8% per year, compared with 5.3% for long-term corporate bonds, and 11.0% for stocks. If you had invested $5,000 in T-bills 50 years ago, it would now be worth $33,272. Growing at 11% in stocks, it would be worth $922,824. (From 1926 to 2000, inflation grew at an average rate of 3.1% annually.)
For long-term investors, stocks offer the best potential for growth. Still, it's smart to understand how bonds work before you dismiss them. Also understand that although stocks may average 11% growth over a long period, over the next 5 or 10 or even 20 years, the average return may be different.
You can learn more about bonds in our Investing Basics area and our FAQ area. There's also a wealth of info at BondsOnline and SavingsBonds.gov and at The Bond Market Association's website.
If you're just looking for a low-risk place to invest some short-term funds, visit our Short-term Savings Center for some tips and leads.
This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.
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