New investors are often inundated with advice on how they should and should not invest their money. However, there are a few tried and true rules for investing money, one of which is to diversify your portfolio. In other words, don't put all your eggs in one basket.
Diversification essentially means spreading your money across different assets and types of investments to reduce the risk of losing everything in the event of a financial crisis.
While you may automatically think of stocks when planning your investment strategy, bonds are another form of investment that can help you achieve the diversification recommended by experts. They also tend to be less risky than stocks and can act as a counter to stock performance. Bonds can also now be an attractive alternative to overnight and time deposits, which are currently losing their value due to low interest rate policies and inflation.
Like many areas of investing, bonds can be very complex, but let's keep it simple for now. Here's everything the average investor should know about bonds.
Bonds = Debt
In short, bonds are nothing more than are debt. It's not uncommon for individuals to take on debt from banks when they borrow money (in the form of a loan) to finance a mortgage or a car, for example.
With bonds, however, the roles are reversed. Individuals or investors loan money to companies and governments that need the funds. You can therefore call companies and governments borrowers in this scenario.
Bonds earn interest
In return for the money they borrow, investors receive interest on their bonds, similar to how lenders charge consumers interest when they lend money. Because bonds earn investors interest at regular intervals, they are often referred to as "fixed income securities" and can help offset losses that may occur if you also invest your money in stocks. Other terms for bonds include "fixed income", "bonds" and "debentures".
The annual interest rate that bonds pay to investors between the time of issuance and the maturity date is called the coupon payment and is usually paid to investors twice a year.
With bonds, your investment is tied up until the maturity date. Unlike stocks, which you can buy and sell at any time. So a 10-year bond must remain untouched for 10 years. It is important to know the maturity date of a bond before you commit your money.
Bonds are priced
Similar to how consumers have a credit score that shows lenders how creditworthy they are and how likely they are to repay their debts, certain types of bonds also have credit ratings that show investors how likely they are to get their investments back.
The highest bond rating is AAA according to the Standard&Poors rating model. Bonds with a rating of C or below are considered particularly at risk of default, which means investors could lose their investment.
When you buy a bond, you should also pay attention to interest rates and inflation rates. Two major risks to bonds are rising inflation and rising interest rates, the latter of which can cause bond prices to fall. Both can cause bonds to lose value.