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To further our discussion about investing basics and your retirement this week let’s examine bonds. How do bonds work? A bond is basically an IOU. Bonds, sometimes called fixed-income securities, are essentially loans to a corporation or governmental body. The borrower (the bond issuer) typically promises to pay the lender, or bondholder, regular interest payments until a certain date. At that point, the bond is said to have matured. When it reaches that maturity date, the full amount of the loan (the principal or face value) must be repaid.
A bond typically pays a stated interest rate called the coupon which is a term that dates back to the days when a bondholder had to clip a coupon attached to the bond and presented to the issuer in order to receive each interest payment. Most bonds pay interest on a fixed schedule usually quarterly or semiannually, although some pay all interest at maturity along with the principal.
There are two fundamental ways that you can profit from owning bonds. The most obvious is the interest that bonds pay. However, you can also make money if you sell a bond for more than you paid for it. As with any security, bond prices move up and down in response to investor demand and they also are sensitive to changes in interest rates. A bond that is sold before its maturity date may be worth more or less than its face value, depending on how favorably its interest rate compares to others.
One of the most important reasons that investors choose bonds is for their steady and predictable stream of income through interest payments. Bonds have traditionally been important for retirees for this reason. Also, though they are not risk-free because a bond issuer could default on a payment or even fail to repay the principal, bonds are considered somewhat less risky than stocks. In part, that’s because a corporation must pay interest to bondholders before it pays dividends to its shareholders. Also, if it declares bankruptcy or dissolves, bondholders are first in line to be compensated.
The bond market often behaves very differently from stocks. For example, when stock prices are down, investors often prefer bonds because of their relative stability and interest payments. Also, when interest rates are high, bond returns can be attractive enough that investors decide not to assume the greater risk of stocks. Interest from bonds can help balance stock fluctuations and increase a portfolio’s stability. And because a bond’s face value gets repaid upon maturity, you can choose a bond that matures when you need to access the money.
If you have questions about the above or any questions related to your retirement planning, don’t hesitate to call.
Jeff Christian CFP, CRPC
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