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{Listen to the audio of this section and be sure to review your workbook action items at the bottom of this page}

Bonds are a great way to mitigate your portfolio against risk, let's talk about it in more detail.

Going back to lesson 6, I provided a high level overview of what bonds are and defined them as a loan that you as an investor, can make to the government, a corporation or an organization to help them raise money and in exchange you’ll recieve earnings based on the interest payments they pay you for the money you loaned them over a specified term. The type of bond issued depends on the entity issuing the bond.

 
Lesson 6 - 12 - Bonds.jpg
 

Bond definitions you should know

Here are a few terms associated with bonds that you should know:

  • The borrower or bond issuer: The entity that issues the bond 
  • Interest: The fee the bond issuer pays you for what they borrowed
  • Face value: The full amount they borrowed 
  • Maturity date: The specific date you are eligible to get your face value back

Bond interest payments happen in advance of you receiving your face value back and most individual bonds have a face value of $1,000.


Types of bonds

Now let’s talk about the different types of bonds:

1. U.S. Government Bonds

These are bonds that are sold to help pay down the national debt and for other federal government projects for instance infrastructure etc. Bonds issued by the federal government are exempt from state and local income taxes and are broken into two:

  1. Treasuries (Treasury bonds and treasury notes)
  2. U.S. Savings Bonds (Series EE bonds and Series I bonds)

 

1. Treasuries

  • Treasury bonds which pay interest every 6 months but have 30 year maturities.
  • Treasury notes which also pay interest every 6 months but have maturity dates of two to ten years.

 

2. U.S. savings bonds

While U.S. savings bonds don't make regular interest payments, they can be purchased at less than their face value and you can get the full face value when you cash them in. So for example, you can buy a savings bond for $50 that has a face value of $100.

U.S. Savings bonds can further be broken into:

  • Series EE bonds which offer tax breaks when used for higher education 
  • Series I bonds which provide protection against inflation by increasing the interest rate as inflation rises 

 

2. Municipal Bonds

Municipal bonds are bonds that are used to fund state and local government projects for instance building schools, hospitals and roads, and are typically exempt from federal and state income taxes.

 

3. Corporate Bonds

These are bonds issued by companies and typically pay higher interest rates than government bonds. They are also higher risk because companies have the chance of experiencing issues or folding completely that would prevent them from being able to pay the interest or face value. They are also subject to federal and state income taxes.

 

Note on interest rates & bonds. When it comes to interest rates, they vary across bonds depending on the risk level, time to maturity and current market interest rates.


So how do bonds hedge your portfolio against risk?

Bonds are less risky than stocks because they provide you with a somewhat predictable return based on the interest payments you’ll receive. However, bonds still carry a level risk and that could come from the bond issuer being unable to make the interest payments.

Government bonds are usually the safest because they are guaranteed by the government, while non-government bonds like municipal and corporate bonds for instance, are given a risk rating. Think of it like a credit score for bonds that can help you as an investor, determine what bonds are safe and most likely to pay the interest and principal and what bonds are considered high risk. High risk bonds will try to make themselves more attractive with higher interest payment offerings.

Here is a bonds rating chart based on ratings from the 3 major financial authorities in assessing bond risk (Moodys, Standard & Poor's and Fitch):

 
 Data source: Barrons

Data source: Barrons

 

What’s the difference between a bond fund and an actual bond?

Bond funds are mutual funds that invest in bonds, while actual bonds as described in the beginning of this lesson, are a loan that you as an investor can make to the government, a corporation or an organization to help them raise money and in exchange you’ll recieve earnings based on the interest payments they pay you for the money you loaned them over a specified term.

A bond fund can have hundred of bonds aggregated together to make up a portfolio.


Where to buy bonds

You can purchase the different types of bonds as well as bond funds via a brokerage of your choice.


 

Use your workbook (located in the investing main menu) to start your bond research using the following pages: 

  • Researching & Buying Bonds