When thinking of investing or generating additional income, beginners generally default to investing in the stock market, inspired by Warren Buffett and/or other great investors.
While the stock market is a great starting point to learn the ropes of the investing world, bonds are also advisable for investors of all ages and risk tolerance.
What are bonds? A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations.
The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that’ll be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment is part of the return that bondholders earn for loaning their funds to the issuer.
Though bond markets are very liquid and active, they can take a second seat to stocks for many retail or part-time investors. They’re often for professional investors, pension and hedge funds, or financial advisors, but that doesn't mean that part-time investors should steer clear of them.
In fact, bonds play an increasingly important part in your portfolio as you age. There are many types of bonds including government, corporate, municipal and mortgage bonds. Government bonds are generally the safest, while corporate bonds are considered the riskiest of the commonly known bond types.
Okay, so if it’s low risk, does it have a high reward? Unfortunately, you probably won’t strike it rich investing in bonds. While bonds are low risk investments, you’re simply getting back the amount you lend plus some interest, casting it as a fixed income instrument.
So why is it important to invest in bonds? Bonds are a great idea if you’re community-minded and/or want a diverse portfolio.
Municipal bonds (“munis”) are issued by state and local governments to fund the construction of schools, highways, housing, sewer systems, and other important public projects. These bonds tend to be exempt from federal income tax and, in some cases, from state and local taxes for investors who live in the jurisdiction where the bond is issued. Munis tend to offer competitive rates but with additional risk because local governments can go bankrupt.
As for diversifying your portfolio, including a mixture of stocks, fixed income instruments, and commodities is your best defense against a financial crisis. In a diversified portfolio, the assets don't correlate with each other. When the value of one increases, the value of the other decreases. It lowers overall risk because, no matter what the economy does, some asset classes will benefit.
Next time, consider mixing things up a bit rather than just sticking to the stock market!