The ABCs of Bonds

While your money is likely to grow faster in stocks than bonds over the long run, it can still make sense to include some bonds in your portfolio, for diversification. Learn more about bonds before jumping into them, though.

A bond is essentially a loan of your money to an entity. The U.S. government’s Department of the Treasury, for example, borrows money by selling bonds known as “Treasuries.” State and local governments issue municipal bonds. Businesses issue corporate bonds. Healthy companies can offer bonds with lower interest rates, while shakier enterprises have to sell “junk” bonds with interest rates high enough to attract buyers willing to accept a higher risk of default.

Most bondholders receive regular interest payments from the issuer at the stated “coupon rate.” For example, a $1,000 bond with a coupon rate of 5% will generate payments of $50 per year. When the bond matures, the “par value” of $1,000 will be repaid. Short-term bonds mature in one to three years, intermediate-term bonds mature in about four to 10 years, and longterm bonds generally mature after more than 10 years.

Note, though, that some bonds are “callable,” meaning that the borrower might choose to pay back the principal early, before maturity. Federal government bonds are never callable. (Before buying any bond, learn its terms.)

You can buy a bond at issue and hang on through maturity, but you don’t have to, as bonds can be traded between investors. Their prices change as prevailing interest rates change. A 3% bond’s price will fall, for example, if interest rates rise and 5% bonds become available. When interest rates fall, existing bonds with higher interest rates will be in higher demand and thus cost more to buy.

With much or most of your longterm money, though, stick with stocks, which tend to outperform bonds. Between 1928 and 2019, U.S. Treasury bonds averaged an annual gain of 4.9%, according to New York University professor Aswath Damodaran, while the S&P 500 stock index averaged a 9.8% gain (including dividends).