Just like in medicine, understanding the fundamentals is key to making confident and informed financial decisions. This week, we return to our series of educational modules highlighting the basic concepts and terminology in finance and investing. The Stocks4Docs podcast focuses more on investing in stocks, however, it is important to understand what bonds are as they will likely make up some part of your portfolio. Let’s break down this topic to get a basic but solid understanding of bonds.
In simplistic terms, a bond is a loan, given to either a company or the government by an investor (you) who will then get paid interest on a certain schedule for the money they’ve loaned. The government or company is considered the bond issuer. And the person who purchased the bond (you) is considered the investor. The government or company issues the bond and also issues a coupon rate, which is basically an interest rate the issuer will pay. This gets paid to the investor (you) on a set schedule. The bond will also be noted to mature, in other words the principal will be paid back to you, in a certain amount of time.
Bonds are issued for various reasons. Government bonds may be issued when there is a project that needs funding (for instance, a city may want to raise funds to build a park). Corporate bonds may be issued when a company has a project it needs to fund. These projects may carry very different amounts of risk, however.
One real risk is that the government or corporation will default and not be able to pay you back your principal. Typically, government bonds are safe and stable, and this does not happen. In the case of corporate bonds, this is a higher risk, and therefore, the coupon rate may also be higher.
The other risk that is discussed is interest rate risk. This occurs when, after you have invested in a bond, another bond comes out very similar to the previous bond, but they are now paying a higher interest rate. You need to decide about trying to sell your bond at a discount.
The price of bonds has an inverse relationship with interest rates, which you could deduce from the interest rate risk as above. If interest rates go down, the bond you bought at a higher interest rate is more valuable and the price will go up.
It’s a good idea for every investor to look at his or her brokerage accounts and take note of the list of available bonds. You can then decide your own risk tolerance level, consider your current stage of life, and contemplate altering the percentage of bonds in your portfolio. Bonds can get more complex and complicated, but we can explore that more together at another time!
Listen to Podcast Episode #42 here https://stocks4docs.org/podcasts/ to learn the basics about Bonds.
And subscribe to the stocks4docs podcast https://stocks4docs.org/podcasts/ to learn more about investing, personal finance, and more!