Bonds are a great way to reduce risk and provide income—as long as you use them correctly.
Almost any investment plan can benefit from bonds, but many investors don’t understand them, thinking they’re boring income investments, and therefore shun this important class of assets. Some income investors view bonds as the ultimate in safety, which they aren’t, and therefore accept risks they aren’t even aware of. By learning what you should do with bonds in your portfolio, you can reduce your overall portfolio risk, earn current income, and obtain capital gains.
We all know that when someone lends money to someone else, that transaction is called a loan, and the amount lent is called the principal. The lender charges interest on the amount of the loan. Over time, the borrower pays back the principal and the interest. If you understand this, you at least know what a bond is, because it’s nothing more than a loan to a borrower, who happens to be a corporation or government entity.
When you buy a bond, you lend the borrower money for a specific duration, known as the maturity of the bond. The borrower pays you interest (the coupon rate) on the borrowed money until the bond matures (reaches the end of its duration), at which point the borrower also pays back the principal. Pretty easy, huh?
Some investors think of bonds as certificates of deposit (CDs) that pay higher interest rates. However, bonds pay higher interest rates because they ...