A bond is essentially a long-term loan. 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" (sometimes called corporate "paper"). 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, called "par value." Most corporate bonds have a par value of $1,000, while government bonds can run much higher.
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 are never 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.
Over the long term, stocks have outperformed bonds handily. According to Jeremy Siegel's Stocks for the Long Run, from 1802 to 2001 (yes, you read that right -- about 200 years), the stock market offered an average nominal annual return of 8.3% per year, compared to 4.9% 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 years), 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. And also to understand that although stocks may average 11% growth over a long period, over the next five or 10 or even 20 years, the average return may be different, possibly significantly higher or lower than 11%.
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Longtime Fool contributor Selena Maranjian doesn't own shares of any companies mentioned in this article.