While stocks involve buying a piece of a company to share in its profits, bonds actually represent debt. A government, corporation, or other entity that needs to raise cash borrows money in the public market and subsequently pays interest on that loan to investors. In other words, a bond does not represent ownership in a company as a stock does. Rather a bond serves as a loan from the investor to the company.
Each bond has a par value or face value and then pays a coupon to investors. For example, a $1000 bond with a 4 percent coupon would pay the investor $40 annually until it matures. Then on maturity, the investor is returned the full amount of the principal (except in the rare occasion when a bond defaults).
As with stocks, there are different classifications of bonds.
In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories:
Municipal bonds, known as munis, are the next progression in terms of risk. Cities don’t go bankrupt that often, but it can happen. The major advantage to munis is that the returns are free from federal tax.
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to twelve years, and long-term is over twelve years.
The key to success in investment is diversification. Whether considering stocks, bonds, or a combination of them, you don’t want to put all your eggs in one basket! Contact Ambassador Advisors for help in this important component of being the best steward of your resources.