Why Should You Invest in Bonds?

Bonds are a loan made by an investor to a borrower, such as a corporation, municipality, or government. When you purchase a bond, you lend money for a specified period. In return, the issuer repays the borrowed amount, known as the principal, on a set maturity date and pays periodic interest throughout the bond’s life.

Bonds as a Source of Income

Bonds generate a regular stream of income through “coupon payments,” which are interest payments made by the bond issuer to the bondholder. These payments are fixed for the bond’s life and commonly distributed semi-annually, though some bonds may pay quarterly or annually. This predictable payment schedule allows investors to anticipate their cash flow, which can be particularly beneficial for financial planning.

The concept of “yield” in bonds refers to the return an investor receives from these interest payments, expressed as a percentage of the bond’s price. While the coupon rate is set at issuance, the yield can fluctuate with the bond’s market price, moving inversely; as bond prices rise, yields fall, and vice versa. For tax purposes, most bond interest income is generally considered ordinary income.

This consistent income stream makes bonds attractive for various financial objectives, such as supplementing retirement income or covering ongoing expenses. Unlike dividends from stocks, which can fluctuate based on company performance, bond interest payments are contractual obligations of the issuer. This reliability helps create a stable cash flow, distinguishing bonds as a dependable component of an income-focused investment strategy.

Bonds for Portfolio Stability and Diversification

Bonds provide stability and diversification to an investment portfolio. They often behave differently from stocks during market volatility, which can help cushion overall portfolio declines. This is because bonds typically have a low or even inverse correlation with stocks, meaning that when stock markets decline, bonds may hold their value or even increase.

Incorporating bonds can effectively reduce overall portfolio volatility, contributing to a smoother investment experience over time. By spreading risk across different asset classes that do not move in perfect lockstep, diversification aims to protect a portfolio from significant losses. High-quality bonds, in particular, are often considered a relatively safe haven for preserving capital.

This capital preservation aspect is especially appealing for investors nearing or in retirement, who prioritize protecting their principal over aggressive growth. Bonds can serve as a counterbalance to more volatile assets like stocks, creating a more resilient and balanced investment mix. The strategic inclusion of bonds helps manage risk and provides a foundational layer of security within an investment strategy.

Considering Different Bond Types

The bond market offers a variety of types, each with distinct characteristics that cater to different investment goals and risk tolerances. Understanding these differences is essential for selecting bonds that align with individual financial objectives.

U.S. Treasury bonds are debt securities issued by the U.S. Department of the Treasury and are considered among the safest investments due to being backed by the full faith and credit of the U.S. government. They are available in various maturities, including Treasury bills (short-term), Treasury notes (intermediate-term), and Treasury bonds (long-term). Interest income from Treasury bonds is subject to federal income tax but is exempt from state and local taxes.

Corporate bonds are issued by companies to raise capital. These bonds generally offer higher yields than U.S. Treasury bonds to compensate investors for the increased credit risk associated with a corporate issuer. The creditworthiness of corporate bonds is assessed by rating agencies, with investment-grade bonds considered less risky than high-yield (or “junk”) bonds. Interest earned on corporate bonds is typically taxable at both federal and state levels.

Municipal bonds are issued by state and local governments to finance public projects. A significant advantage of municipal bonds is that the interest income they generate is generally exempt from federal income tax. If you purchase a municipal bond issued within your state of residence, the interest may also be exempt from state and local income taxes, making them particularly attractive for investors in higher tax brackets. Municipal bonds can be either general obligation bonds, backed by the issuer’s taxing authority, or revenue bonds, secured by the income generated from a specific project.