If you are considering bonds as part of your portfolio, knowledge of the basics of bond investing would be of extreme use to you.  A bond is different from normal investments in several aspects that will be discussed here.

A bond is basically a loan.  That’s the bottom line, so if you buy a bond, you are in effect purchasing the issuer’s word that the bond will be repaid with interest over an agreed period of time.  The issuer of the bond can be a public or private company that is issuing bonds rather than a share flotation on the stock market to finance their company, the government, issuing a Treasury bond or local governments to finance local roads, schools and other projects.

The issuer sets the interest rate and the interest is paid at agreed set time periods. Like shares, a bond’s price, should you wish to sell it, can vary although the interest rate remains constant.  In some circumstances this can have a significant effect on the yield, either up or down. 

Payment of a bond cannot be requested from the issuer until after its maturity date, which can be up to 30 years, after which repayment from the issuing company must be made.  If you sell the bond on to a third party, the original maturity date still stands, and the buyer has wait until that date before they can request repayment from the issuer.

The sale price of bonds varies according to the interest rate.  Keep in mind that if you purchased a $10,000 bond at a fixed interest rate of 5%, and the rate subsequently rose to 7%, then nobody is going to buy your bond, if you wanted to sell it, at $10,000 at 5% if there are other bonds they can buy at 7% for the same price.

Similarly, if the interest rate drops to 4%, your price will rise because people want the advantage of the higher interest rate, rather than purchasing another $10,000 bond at 1% lower.

There are a number of risks associated with purchasing bonds, and you would be wise to find out about these before making a decision.  The first is the maturity date.  The longer you have to hold the bond, the greater might be the effect of changes in interest rates.  This might be a positive or a negative change, both in interest rates and in the effects they have on your bond. 

Secondly, like any investment, there is the risk of inflation.  If inflation results in the bond’s interest rate being overtaken, then you can lose on the bond.  Obviously this is not a desirable outcome, so you should try to keep an eye on longer range forecasts of potential interest rate changes, and if you spot that the time will shortly be right for an interest rate increase to help reduce inflation, then that may well be the best time to sell.

There is also the risk that the issuer might not have the money to pay the bond at maturity.  This is not as unusual as you might think, and it is something to keep in mind if purchasing bonds for relatively unknown companies.  Usually the bonds tend to be paid, but it is a distinct possibility, especially in the current economic situation.

The lowest risk bonds are the Treasury Bonds that are underwritten by the federal government.  The other government bonds are in the same category, though the municipal bonds have less security than government bonds due to the relative cash pools each have access to. 

Mortgage backed bonds offer better yield than the government bonds, and are pretty secure since they are backed by pools of mortgages, not individual ones, whereas corporate bond have a fairly high risk of defaulting payment due to the insecure nature of private companies.  However, their interest rate is higher to justify the added risk taken. 

There are one or two other types of bonds, such as international bonds that have the added complication of currency fluctuations.  Bond purchase, therefore, must be done with your eyes open, though there are many benefits, the first of which related to diversification.

Stocks respond in a certain way to market fluctuations than bonds do, and it is frequently desirable to have investments in your portfolio that do not all react in the same way to increases or reductions in interest rates or to government national or foreign policy.  If you hold it to maturity, a bond will protect your investment, which is what few other methods of investing are able to do.

A bond can also provide you with a steady income through the regular interest rates than are normally paid from four times to twice annually, and this is of prime concern to many who want to invest but for whom cash flow is also desirable.  In fact more people would probably invest in bonds if they had the glamour of stocks with their regular swings and big money gains over very short time periods. Bonds do not have this, and are considered by many to be pretty dull investments that don’t keep the investor interested in the markets.

However, there is no reason why your portfolio should not include elements of both. Bonds might seem to offer a relatively insignificant immediate return, but they do protect your investment which is an advantage.  A knowledge of the basic of bond investing will enable to make the right decision.

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