The US bond market’s value is $46 trillion. It is comparable in size to the US stock market. At $119 trillion, the global bond market is even larger. The reason why the bond market is so large is in part because governments issue bonds, not stocks. For companies, bond financing can also be a more attractive source of financing than equity. PIMCO Investments (Introduction to Bonds)
Today, market uncertainty and volatility has become the short term rule, and not just the exception. Now more than ever, bonds can offer important benefits to help you stay on track with your long-term wealth goals with less risk.
Historically, bonds have offered greater stability than riskier investments like stocks, real estate or commodities. Bonds can also help you diversify the assets in your portfolio and potentially smooth out some of the stock market volatility and rough spots.
Bonds are basically loans from investors and a source fixed income for investors. A company, state or government issues bonds to raise money and capital. When an investor buys a bond they give the issuer – the company or government who issued the bond – a loan. Often, the bond issuer agrees to pay its investors periodic “fixed” interest payments (hence the name fixed income) while the loan is outstanding and to pay back the full loan at the end of the bond’s life (called maturity).
The amount that is given to the issuer is called the principal, or face value, of the bond. In return, the issuer agrees to pay the investor both the face value of the loan on a specific date (the “date of maturity”) and to pay the investor periodic interest payments, known as coupons, in specific intervals.
Source: PIMCO Introduction to Bonds
The coupon is periodic interest payment that the bond holder receives from the issuer from its issue date until it matures. The coupon rate (expressed as a percentage) is calculated by adding the sum of coupons paid per year and dividing it by the bond’s face value. Often coupons are paid semi-annually.
Yield, which is often used when discussing bonds, is the annual net profit that an investor earns on an investment. Yield takes into account the bond’s fluctuating changes in value and is usually reported as an annual percent figure. The interest rate is the percentage charged by a lender for a loan. The yield on new bonds reflects interest rates at the time they are issued.
Unlike stocks, bonds issued by companies do not generally give investors ownership rights. Instead, bonds provide a stream of income. When held in a portfolio with stocks, bond investments can offset some of the volatility in the equities market.
Bonds can play an important role in diversifying a portfolio. Three key potential reasons to consider bonds:
- Defense Against Capital Loss — Barring default, the principal value of a bond is expected to be returned to the investor at maturity. This can make bonds attractive to risk-averse investors who are concerned about losing capital.
- Income — Bonds can provide investors with a source of income in the form of coupon payments. Often coupon rates are set, so investors can receive this income during different market conditions.
- Diversification — Bonds may help diversify a portfolio of riskier assets like equities and this is generally due to the low to negative correlation of bonds with other asset classes.
Bonds can be issued by companies or governments when they want to raise money. There are several types of bonds available for investing, including:
- Government bonds – Bonds that are issued by a government. These are lower yield because the government guarantees that these bonds are backed by the full faith and credit of their government.
- Corporate bonds – Many public and private companies issue bonds to help finance their ongoing operations. These bonds can often offer higher yields than municipal or U.S. Treasury securities, although they may entail a greater risk of default.
- Agency bonds – Debt securities issued by government sponsored agencies for public purposes, such as increasing home ownership or supporting small businesses.
- High-yield – Bonds with ratings below BBB are often referred to as “junk” bonds. These bonds typically provide higher yields than investment- grade bonds, but have a higher risk of default.
- Municipal bonds – Municipal bonds, or munis, are debt securities issued by state or local governments to finance public projects. Interest income is typically free from federal income taxes, and if held by an investor in the state of issuance, may be exempt from state and local taxes as well.
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All investments contain risk and may lose value.There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.