Stocks and bonds are often lumped together, but the two could not be more different.
In this video from our YouTube channel, we explain exactly how bonds work and make money for bondholders, and the pros and cons of owning bonds instead of stocks.
A full transcript follows the video.
Narrator: Hey! I'm Motley Fool contributing writer Maurie Backman, and on this episode of FAQ, we're walking through what bonds are, and whether or not they might be a good investment for you.
When companies need to borrow money, they can borrow it from banks, or they can borrow it from regular people like you and me. That's where bonds come into play.
Bonds are debt instruments issued by companies, as well as municipalities like cities, states, and counties. The U.S. government also issues bonds – Treasury bonds.
When you buy bonds, you're essentially agreeing to lend the issuer a certain amount of money for a preset period of time. The issuer, in turn, agrees to pay you a certain amount of interest over the life of your bonds, and then return your principal investment once the bonds mature, or comes due.
Let's imagine you buy $10,000 worth of Company X's bonds at 4% interest for a 10-year term, and you hold those bonds until maturity. That means you'll collect two $200 interest payments each year for a total of $400, and then, you'll get your original $10,000 back after a decade.
But collecting interest isn't the only way you can make money from bonds. Bond values can fluctuate based on how the market or a given issuer is doing, so you might have the option to sell your bonds above face value, or for a price that's higher than what you paid for them, and profit as a result.
Now some people like to lump bonds and stocks into the same general "investing" category, but the two are very different from one another. When you buy bonds, you're lending the issuer money, and it's obligated to pay you interest and return your principal later on.
When you buy stocks, you're actually getting an ownership stake in the issuing company. If that company then does well, it might share its wealth in the form of dividends. You might also get voting rights that give you a say as to how that company operates. With bonds, you get paid regardless of whether the issuer is profitable – but you don't get a say in how it manages its money. And remember, some bonds are issued by the government itself – and the government certainly doesn't want your opinion on how it should run.
There are plenty of good reasons to add bonds to your portfolio. First, though there's no such thing as a risk-free investment, they're a relatively safe one compared to stocks because their values don't tend to fluctuate quite as rapidly. And the better a job you do of vetting bond issuers, which you can do by looking up their credit ratings, the less likely you are to lose money on a bond investment.
Bonds are also a good way to secure a steady stream of income in the form of the semiannual interest payments we talked about earlier. Stock dividends, by contrast, aren't guaranteed, because corporations aren't contractually obligated to pay them the same way bond issuers are required to pay interest.
Furthermore, usually, when you collect dividends or interest, you're required to pay taxes on that money. Some bonds, however, allow you to earn interest without owing the IRS taxes. Municipal bonds, for example, are always exempt from interest at the federal level. And if you buy municipal bonds issued by your home state, you'll avoid state and local taxes as well. Treasury bonds, meanwhile, are always exempt from state and local taxes.
On the other hand, bonds do have their drawbacks. First, they require you to lock your money away for a potentially lengthy period of time, so if you're the type who fears commitment, you might have some issues with that. From a financial perspective, tying up your money for what could be 10 years or more exposes you to something called interest rate risk.
We just learned that bonds pay a certain amount of interest, depending on what their contracts call for. But what happens if you buy 10-year bonds paying 4% interest, and a month later, that same issuer offers bonds at 4.5% interest? Suddenly, your bonds lose value, and you lose out on the added income that higher interest rate would've given you.
Furthermore, while bonds are considered safer than stocks, they've historically delivered lower returns. If you load up too heavily on bonds, you might limit your portfolio's growth over time.
Another thing you should know about bonds is that they don't trade publicly, so it's harder to know whether you're buying them at the right price. While you've probably heard of the New York Stock Exchange, a central bond exchange doesn't exist. Now there is a group called the Financial Industry Regulatory Authority, or FINRA, which regulates the bond market to some extent. But bond trading is still not as transparent as stock trading.
Ultimately, if you're going to buy bonds, you might consider an approach called laddering. All that means is buying bonds that mature at different intervals rather than sinking a bunch of cash into bonds with a single maturity date. That way, you get access to your money along the way, leaving you free to reinvest it in other places or snag higher bond interest rates as they become available.
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