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How Do Bonds Work?

September 10, 2017 · 4 minute read

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How Do Bonds Work?

When you hear the word bonds, you may think of the savings bonds your family members gave you on your birthday as a child. And you may not have given them much thought since.

But, as a generally lower-risk investment than stocks that offer a reliable source of interest payments, bonds can (and should) be a part of your grown-up investing strategy, too. Read on for an explanation of how they work—and how they can work for you.

What Are Bonds?

In short, bonds are loans you make to either a company or a government entity for a fixed period of time. The specific terms of the deal vary, but basically: You give someone money, they promise to pay it back in the future, and they pay you interest until they do.

For example, you might buy a GE bond that lends the company money for 20 years at 4% interest. For each $1,000 you invested, you would get $40 per year for 20 years; then you’d get your $1,000 back.

Why Invest in Bonds?

There are two good reasons to buy bonds—income and safety. Bonds pay interest at a fixed rate, usually twice a year. People in retirement who need a reliable source of income often invest in bonds.

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High quality, investment grade bonds (more on this later) are typically safer, because the borrower is less likely to default on their promise to repay your investment. This doesn’t mean you can’t lose money if you need to sell the bond before it matures, but the issuer is unlikely to go broke. The price of bonds can fluctuate, but usually much less than the price of stocks. They are used in a portfolio to smooth out the volatility of stocks and reduce the risk of your overall investment strategy.

Who Issues Bonds?

There are four broad categories of bonds available to most investors:

• Treasury Bonds: Bond issued by the U.S. government.

• Corporate Bonds: Bonds issued by a corporation.

• Municipal Bonds: Bonds issued by a state or local government or agency (for example airports, school districts, and sewer or water authorities).

• Mortgage and Asset Backed Bonds: Bonds that pass through the interest on a bundle of mortgages or other financial assets such as student loans, car loans, or the accounts receivable of companies.

The main difference in them? Risk. The U.S. government (probably) won’t go broke, but a company might. Because expected return is tied to risk, you are likely to see higher returns with a corporate bond than with a treasury bond. Municipal and mortgage and asset backed bonds vary widely in risk.

Just How Risky Are Bonds?

Depends on the issuer. To help investors understand the risk, corporate bonds are rated for risk by agencies such as S&P and Moody’s. The precise scale varies with the rating agency, but bonds rated AAA to BBB by S&P are considered “Investment Grade,” those rated BB+ to C are high-yield, or “junk” bonds. Bonds with a D rating are in default and not paying interest.

Muni and asset backed bonds are also rated by agencies on a similar scale. Muni ratings depend on the credit quality of the issuing city or state, while asset backed bonds depend on the quality of the assets backing the bonds. As a rule, investors demand higher interest on lower quality bonds. High-yield bonds yield more because the risk of default is higher. Note that ratings can (and do) change over time.

Bonds can also go up or down in value if interest rates change. You can buy a 20-year bond that only has 8 years left on it in the bond market. The price you’d pay for the bond depends on whether interest rates on similar bonds went up or down since it was issued. If this kind of bond pays 4% today, you would pay more than $1,000 for one issued some years ago that pays 5%. An old bond that pays only 3% would be worth less, since interest rates today are 4%.

Should I Buy Bonds?

Unless you are a very aggressive investor, you should probably have some bonds in your portfolio. Some people can’t stomach the wild swings of stock values. Adding even a small percentage of bonds to your investment mix can smooth out the volatility and might help you from panic selling when the market drops.

With that said, buying individual bonds isn’t always the best approach. Since most bonds have a face value of $1,000, it can be difficult and expensive to build up a diversified bond portfolio. Unless the bond portion of your portfolio is several hundred thousand dollars, it usually makes more sense to invest in bond mutual funds or exchange traded funds (ETFs). A typical bond fund will generally hold between dozens and hundreds of individual bond issues.

Bond ETFs generally contain bonds of similar types of issuer, maturity range, and quality.
(Again, the issuer is the entity that borrowed the money. Maturity is how long the bond holders have to wait for their money. The longer it is, higher the interest rate they usually get, but also the greater the risk that something will go wrong. Quality is the financial strength of the issuer. How likely is the borrower to not be able to pay back your investment?)

If you invest in SoFi Invest®, all but our most aggressive portfolios contain at least some bonds. We currently use nine different bond ETFs to build our portfolios. Each ETF contains different kind of bonds, which lets us use the right combination of bonds for each portfolio.

Not sure what the right investment strategy is for you? An investment account with SoFi makes it easy: Our technology helps you determine the right asset allocation mix for you, while advisors are available to offer you complimentary, personalized advice. Consider working with a SoFi Invest advisor today.


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