Unlike stocks, which represent equity or ownership in a company, bonds are loans. When you invest in loans, you are actually investing in debt. You loan your money to an organization for a set period of time. The organization uses the money to fund its operations and pays you interest over the life of the loan. When the bond’s term ends, you receive your principal back.
There are different types of bonds, most of them classified according to the type of organization issuing them. Let’s take a look at two types of bonds that are popular with long term investors.
First up are Treasury bonds. Treasury bonds were designed for serious investors. They are long term government securities that have a maturity date of at least 10 years. The longest Treasury security has 30 years until maturity. They pay interest every six months and are sold in lots of $1,000. These bonds are most attractive when interest rates are very high. Treasury bonds are great for locking in a high rate of interest for an extended time. You can currently purchase a 30-year treasury bond yielding 1.33%, which is very low compared to its historical average.
Here’s how it works.
Let’s say you purchased a 20-year bond for $1,000 with a 1.2 percent interest rate. You will receive an interest payment of $6 every six months. These payments will continue for 20 years. After the 20th year, you would redeem the bonds and receive your full $1,000 investment back.
The great thing about bonds is that they allow you to have a fixed income stream. Every six months, you know that you will be receiving a payment. An added bonus is that you can always sell the bond to another investor if you choose to.
When you sell your bond, you will get less than the original purchase price if the current yield is higher than your bond yield. Conversely, you will get more than the original purchase price if the current yield is lower than your bond yield.
My favorite types of bonds are corporate bonds. Corporate bonds are debt securities that are issued by an individual company. Companies like Coca Cola and Pepsi issue corporate bonds for a variety of reasons. They can be used to finance expansion, raise cash, or retire higher interest debt. Corporate bonds can be purchased in blocks of $1,000 and pay interest semiannually. The maturity date of corporate bonds can vary greatly. Some bonds mature in as little as a year, while others can be held as long as 30 years.
Corporate bonds are known for their higher interest rates. They are rated from AAA to F. A bond with a higher rating pays a lower interest rate than a bond with a higher interest rate. They are priced and listed on major exchanges. Bond prices rise as market interest rates fall, and bond prices fall as interest rates rise.
Corporate bonds have a greater risk than many types of bonds because the individual company backs the bonds. Therefore the interest rates offered on corporate bonds are much higher than other bonds. Corporate bonds are rated based upon the financial strength of the company. Bonds are rated by Moody’s and Standard and Poor’s. Bonds of the highest quality will receive an AAA rating, whereas bonds of lower quality will receive a CCC or D rating. Corporate bonds can be purchased through a stockbroker or simply by visiting the company’s website.
In my opinion, bonds are great for older investors. The dividend payments provide a consistent income stream, and the asset class itself provides diversification outside of equities to protect the portfolio against market crashes. Bonds are also good for young investors in a very small quantity, specifically, no more than 10-20% to help diversify the portfolio.
Mark Riddix is the founder and president of New Horizons Financial Management, an independent investment advisory firm that provides personalized investing and asset management consulting. Mark is a regular contributor to Seeking Alpha and has written financial columns for Baltimore and Washington, D.C. area newspapers.