Bonds, Explained

Stocks have outperformed bonds over most 20-year and 30-year periods, and between 1802 and 2017, stocks averaged annual postinflation gains of 6.8 percent, while bonds averaged just 3.5 percent. Despite that, you might include some bonds in your portfolio for diversification, especially if you’re in or near retirement. First, though, be sure you understand what bonds are.

Bonds are essentially long-term loans. If a company or government 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 on shaky ground attract buyers with high-interest-rate “junk” bonds.

If you buy a $1,000 bond with a “coupon rate” of 5 percent, you’ll receive $50 per year in interest payments. When the bond “matures,” you’ll be repaid your principal (the sum you originally loaned, the bond’s “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.

Investors don’t necessarily buy a bond when it’s first issued and then hold it to maturity, for several years or decades. Bonds are often traded among investors, with their prices rising and falling in reaction to prevailing interest rates. When rates fall, people tend to bid up bond prices. After all, if banks are offering 2 percent, a 5 percent bond will be appealing. When interest rates rise, newer bonds with higher interest rates will be more appealing than older bonds with lower rates.

Bonds can make sense for your portfolio, but if you’re looking for investment income, consider dividend-paying stocks as well. To see many stocks we have recommended, some of which offer dividends, try our “Motley Fool Stock Advisor” newsletter via fool.com/services.