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What Are Bonds?

A bond is essentially a loan offered directly to investors which can include institutions or individuals. As with any loan, similar to those for homes and automobiles, interest is charged on the loan amount at a fixed rate. When a company or the United States government sells bonds on the open market they are seeking investors to purchase these loans at a predetermined interest rate to raise capital by issuing debt. When you see on the news that 10 year treasuries are currently 5.25% that means if you own one US 10 year treasury that you will receive a bond interest payment, also known as a coupon payment, of 5.25% interest on the bond amount. There are caveats however to owning bonds which should be understood by investors

One of the primary issues with bonds that institutional investors are aware of but sometimes individual investors are not is that the face value of the bond and interest rates are inverse in relation to each other. What this means is that when interest rates increase bond values decrease and and when interest rates decrease bond values increase. The reason why this is important is because bonds in mutual funds are traded on the secondary market and will fluctuate in value based on current market interest rates. Financial advisors will often recommend purchasing bonds as interest rates decrease which will see an increase in principle value and to avoid bonds if it is likely that interest rates will be increasing in the near future. This is because many investors do not purchase a 10 year bond and hold it to maturity collecting the interest payments every year. Most investors buy and sell bonds on the secondary market and therefore are only interested in their actual value. Where small investors get hurt is by purchasing hundreds of thousands of dollars in bonds and then seeing interest rates increase substantially in a short period of time. This could potentially lead to a reduction in principal of 20% to 30% if not more.

As mentioned earlier most bonds are traded on the secondary market and are not normally purchased directly from the primary issuer. When Ford or the government has a new bond issuance it is very rare for individual investors to purchase these bonds directly from the organizations in question. The way most investors purchase bonds is by participating in bond mutual funds which helps diversify exposure to interest rate fluctuations and minimize market risk. You can still have a loss of principal but it should be substantially less as the fund is actively reallocated by portfolio managers. Individuals can purchase bonds directly from the United States government but that is normally only recommended for more sophisticated investors.

Bonds should always be a part of a diversified investment portfolio either by owning them directly or investing in a bond mutual fund. Since a bond works like any other loan were a principal amount is lent at a fixed interest rate they are easy to understand both in concept and execution. Investors only need to keep in mind the risk of bond face value in relation to interest rate direction to protect themselves and their principal. Bonds historically are the second best performing investment behind stocks and as a result can lead to significant returns if invested in wisely.