In the last edition of Adulting with Abby, we covered types of and investing in stocks. A close companion to stocks are bonds. While they both are similar in function, they are listed differently for a reason. Today, we will differentiate the two and see how bonds actually work when investing.
Stocks: when a company issues a piece of itself in exchange for cash.
Bonds: when a company issues a debt with an agreement to pay interest for using the money.
Stocks are typically how a company continues to grow funds. Bonds are for whenever companies need the money to get out of a bind. People who deal with bonds are like loaners. They loan money to a corporation, and in return, the company pays them back plus some interest rate. On rare occasion, bonds can default, and that is when the issuer or company cannot pay back the loaner.
Types of Bonds
Just like stocks, there are various types of bonds, and the most popular are as followed.
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Savings bonds– the easiest and safest bond to buy; backed by the government; will not lose principal; tax-free; not easily transferable and typically cannot be cashed out within the first year of purchase.
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U.S. Treasuries– another very safe investment; provides individual bonds until maturity (the time between when the bond is issued and when it is redeemable); no risk of default; interest rate risk is not a factor.
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Municipal– issued by cities, states and local government; federal tax-free; most useful for investors in higher tax brackets (people who make higher income to be taxed on).
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Mortgage-backed securities– when banks issue groups of home mortgages and sells them as one security; offers high yield than U.S. Treasuries; offers more risks because of homeowners paying to pay the mortgage ahead of time.
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Corporate– funds corporations sell to generate more profit; higher risk of default; multiple options for risk and return of investment for investors; integral part of a diversified income-oriented portfolio.
Why Bonds?
While stocks are often considered first, bonds can have more benefits than stocks. First, the income is fixed rather than volatile or all over the place. Bonds are easier to cash out if you are wanting to live off of an investor’s income.
Adding diversity to an investment portfolio will also reap more benefits and reduce risk factors. By doing this, bonds can preserve capital and, once again, reduce volatile behavior, especially when the market is falling.
Bonds are typically quicker to redeem due to having shorter-year timelines. This protects the value of the bonds, for the risk of suffering a loss is less likely to happen over short time frames. Lastly, bonds are easier to reduce tax troubles because certain bonds are tax-free.
Bonds and stocks aren’t exactly the most fun topic, but they will become a part of your life if you decide to invest. We have only skimmed the basics. I encourage you to use the links within these articles plus more research on the topics if you are really wanting to invest in either stocks or bonds. Sometimes hiring a broker is necessary, or you can schedule a consultation with your bank. However you decide to proceed, do it with certainty and knowledge of all the benefits and risks.