Bond Basics Part 1: What, Who and Why?
A useful guide to the world of bonds...
Be sure to read the rest of the Bond Basics series:
What Are Bonds?
- An interest-bearing instrument which promises to pay a stated amount of money at some future date.
- Bonds are redeemed at the end of a term, called a maturity date. Some bonds have “call dates.” Issuers may call bonds earlier than its maturity date if it suits them at that time. Other bonds have “put features.” This is the opposite of a call date. “Put” allows the holder to sell the bond back to the issuer at a predetermined price before the stated maturity date.
- When you buy a bond, you are in effect “lending money” to the issuer, much like an “I.O.U.”
Who Issues Bonds and Why are They Issued?
- Bonds are issued by many types of entities, including: Governments, Corporations, Municipalities and Federal Agencies.
- Bond issuers issue bonds generally to fund their operation. They pay the owner interest so long as the bond is outstanding.
- When a bond is issued, the issuer assumes that they can earn more in their business than they are paying out on the interest payments. For a corporation, by example, this means they feel their “return on equity” will exceed their interest payment rate.
- Bonds can be issued to fund an acquisition, for general corporate purposes or to pay off a maturing bond issued previously.
Why Invest in Bonds?
- Most financial advisers, investment advisers or stockbrokers recommend that portfolios are properly “balanced,” otherwise known as asset allocation.
- Bonds are generally more stable than equities and have a predictable stream of income, acting as a “shock absorber” in the overall scope of a portfolio. See the chart below, which proves that over time, using bonds to diversify lowers the risk of a portfolio, without sacrificing returns.
- Risk in this case is measured as ‘standard deviation of return.' (Data courtesy of Ibbotson)
Using Bonds to Diversify
Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970–2003. Portfolios presented are based on modern portfolio theory. Data courtesy of Ibbotson Associates, Inc. The above charts are for illustrative purposes only and are not indicative of actual or anticipated future returns. This information is not intended to be used as the basis for investment decision, nor should the information be construed as advice designed to meet your particular needs or the needs of any individual investor.
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