Bonds
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Bonds are one of the most fundamental investment instruments you can include in your portfolio. When you buy a bond, you are essentially lending money to a government, municipality, or corporation. In return, the issuer promises to pay you interest at regular intervals and to repay the original amount, known as the principal, when the bond reaches its maturity date. Bonds are favored by investors who seek more predictable returns compared to stocks.
To understand how bonds work, you need to know a few key terms:
- Principal (or face value): the amount you lend to the issuer and expect to get back at maturity;
- Coupon: the fixed interest payment you receive, typically paid annually or semi-annually;
- Yield: the effective rate of return you earn on the bond, which can change depending on the bond’s price in the market;
- Maturity date: the point in time when the issuer repays the principal and the bond expires.
The difference between investment-grade and junk bonds is important for risk management. Investment-grade bonds are issued by entities with strong credit ratings, meaning they are less likely to default but usually offer lower yields. Junk bonds, also known as high-yield bonds, are riskier because the issuers are more likely to default, so they offer higher potential returns to compensate for the increased risk.
Suppose you buy a $1,000 government bond with a 4% annual coupon and a 5-year maturity. Every year, you receive $40 in interest payments. At the end of five years, you get your $1,000 principal back. This predictable stream of income is why many investors include bonds in their portfolios, especially if you want more stability or need steady cash flow.
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