Have you ever heard that bonds should be part of a “diversified” investment portfolio? You may be asking, what are bonds? Bonds are a type of investment and should be avoided in today’s economic climate.
What Are Bonds?
A Bond is basically debt in which an investor agrees to loan money to a company or a government entity in exchange for a fixed interest rate. This interest rate is usually paid by the bond issuer twice a year.
A bond consists of the following:
- Par Value: Initial price of the security. Usually bonds are sold in multiples of $1000.
- Time to Maturity: Longer the maturity of a bond, greater the amount of time its interest payments would be affected by interest rates and reinvestment risks.
- Coupon Rate: Interest or income, price of money or cost of borrowing money, influenced by risks that an investor is taking to purchase fixed-income securities. The higher the coupon rate, the riskier the bond is.
When you purchase a bond, you are agreeing to lend a company or a government entity a certain amount of money for certain time period. During this period, you receive fixed interest payments throughout the time you hold the bond. When the time period is up, the borrowing entity returns the money you loaned them.
Bonds can be bought on the open market through brokerage firms or directly from the entity. Bonds may be purchased higher or lower than the par value.
- Buying at a premium: This is the purchase of a bond higher than it’s par value. The reason for this is that if you purchase a bond that has an interest rate or coupon higher than what the current market is offering, than the bond would be worth more.
- Buying at a discount: This is the purchase of a bond less than it’s par value. The reason for this is that if you purchase a bond that has an interest rate or coupon lower than what the current market is offering, than the bond would be worth less.
The value of bonds are determined by interest rates. As interest rates go up, the value of bonds go down. If interest rates go down, then the value of bonds go up.
Why Not to Buy Them
Most investment advisors recommend holding a percentage of your portfolio in bonds or bond funds. I do not simply because of the current economic environment.
Interest rates are now at an all time low, and they can’t go much lower. Therefore, they have only one way to go and that is up. When rates go up, then the value of bonds or bond mutual funds go down.