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Bonds are a way for an organization to raise money. Let's say your town is seeking investments. In exchange, it promises to pay back investments with interest over a specified period of time.
For example, you might buy a 10-year, $10,000 bond paying 3% interest. In exchange, your town pays you interest on that $10,000 every six months and returns your $10,000 after 10 years.
There are a few ways to make money by investing in bonds:
Bond prices can fluctuate, giving bond traders the opportunity to make a profit. For example, if you buy $10,000 worth of bonds at face value -- meaning you paid $10,000 -- and then sell them for $11,000 when their market value increases, you can pocket the $1,000 difference.
Bond funds take money from many different investors and pool it for a fund manager to handle. Usually, this means the fund manager uses the money to buy an assortment of individual bonds. Investing in bond funds is even safer than owning individual bonds.
Bonds come in a variety of forms, each with its own set of benefits and drawbacks:
Unlike stocks, most bonds aren't traded publicly but trade over the counter, which means you must use a broker. Treasury bonds, however, are an exception. You can buy those directly from the U.S. government at TreasuryDirect without going through a middleman.
The problem with this system is that investors have a harder time knowing whether they're getting a fair price because bond transactions don't occur in a centralized location. A broker, for example, might sell a certain bond at a premium (meaning above its face value). Thankfully, the Financial Industry Regulatory Authority (FINRA) regulates the bond market to some extent by posting transaction prices as that data becomes available.
It makes sense to buy bonds when you want a fixed-income investment or need to reduce risk and volatility in your portfolio. Here are some situations when investing in bonds could be a good choice:
Most people are advised to shift away from stocks and into bonds as they get older. It's not terrible advice, provided you don't make the mistake of dumping your stocks completely in retirement.
A bond is a debt instrument issued by a government or a corporation to raise money. Investors who buy bonds receive a fixed return based on the bond's interest rate.
Most of us are used to borrowing money in some capacity, whether it's mortgaging our homes or bumming a few bucks off a friend. Similarly, companies, municipalities, and the federal government borrow money, and they use bonds to do it.
Bond prices normally rise for the following reasons:
Yields, or the interest rate a bond pays, and bond prices tend to have an inverse relationship, meaning they move in opposite directions. If interest rates increase, prices for existing bonds are likely to fall because they offer lower rates than newly issued bonds.