Bonds, investment bonds

Between 1928 and 2021, the S&P 500 index averaged an annual growth of 10.1 percent (with dividends reinvested), while U.S. treasury bonds averaged 4.9 percent. It’s hard to beat the stock market for building wealth over long periods, but over short periods, stocks can fall in value.

So you may also want to invest in some bonds for diversification’s sake — especially as you approach and enter retirement — or for short-term income.

Be sure you understand what bonds are and how they work first, though.

Think of bonds as loans, and often long-term ones. When you buy a bond from a company or government, it’s borrowing that money from you and promising to pay you a certain rate of interest.

Bonds sold by the U.S. government’s Treasury Department are called Treasuries and have minimal risk. State and local governments issue municipal bonds, while businesses issue corporate bonds. Companies with a relatively high risk of defaulting attract buyers with high-interest-rate “junk” bonds.

If you buy a $1,000 bond with an interest (or “coupon”) rate of 3 percent, you’ll receive $30 per year in interest payments. When the bond “matures,” you’ll be repaid your principal (the loan you originally made — the bond’s “par value”). Most corporate bonds have a par value of $1,000, while government bond par values can be much higher. Bonds can reduce a portfolio’s overall volatility. They can provide a reliable stream of income, via interest rates that can (but may not) outstrip inflation, and if you hold your bonds to maturity, the risk of losing your money can be low. If you sell your bond before maturity, though, its value may be lower if interest rates have risen, making your bond’s lower rate less attractive. Many investors don’t hold onto bonds for years until maturity, and bonds are often traded between investors, with their prices rising and falling in reaction to prevailing interest rates.

You’ll find some model portfolios featuring bond funds at our “Rule Your Retirement” service at Fool.com/services.