Investing in bonds can help balance your portfolio, especially during volatile market conditions. Historically, a diversified portfolio has provided competitive returns with less risk than a portfolio solely invested in stocks. Before adding bond investments to your portfolio, however, it's important to understand what bonds are and how they work.

How Bonds Work

When you purchase a bond, you're giving a loan to the issuer. The issuer, such as a corporation or government, agrees to repay the loan with interest within an agreed amount of time.

The types of bonds offered vary according to the issuer:

  • The federal government issues Treasury bonds to finance the national debt and government programs.
  • State and city governments issue municipal bonds to help pay for roads, schools, sewers and other public works projects.
  • Public and private corporations issue bonds to help their businesses grow.

Interest and Yield

Bond investments pay interest at a rate set by the issuer. Usually, the issuer agrees to pay interest on a regular basis such as quarterly or semiannually. The yield on a bond, which is the amount you earn, is calculated by dividing the bond's annual income by its price.

For example, a bond priced at $1,000 that pays $80 in income has a yield of 8% (80 divided by 1,000). Issuers typically repay the face amount (principal) when the bond matures. Keep in mind that the price of a bond can change after it's issued, which could change the yield even though its interest rate stays the same. Generally, as interest rates rise, bond prices fall.


Maturity

A bond's maturity can be as long as 30 years. The maturity date is the date that the bond comes due and must be repaid.

A zero-coupon bond is issued at a deep discount and redeemed at maturity for its par value, or amount the bond is worth. For example, you could buy a bond at a discount of $400 and redeem it at maturity for $1,000. Although the amount at maturity is not guaranteed, some investors prefer zero-coupon bonds because they can estimate in advance approximately how much their investment will be worth.


Bonds and Their Risks

You can invest in many types of bonds with varying levels of risk. Higher risk bonds generally will have higher interest rates to offset the additional risk. Risk factors include:

  • Time Until a Bond Matures
    A longer maturity date exposes the bond to more interest rate fluctuations.
  • Credit Risk
    The risk that the issuer won't meet its payments.
  • Inflation Risk
    Like any investment, a bond has inflation risk, meaning that inflation could outpace a bond's interest rate.

Bonds can be categorized as follows, from low to high risk:

  • U.S. Treasury Bonds
    These are the lowest risk bonds, because the federal government backs them. Other U.S. government agency bonds also are considered low risk, and their yields often are slightly higher than U.S. Treasury bonds.
  • Mortgage-Backed
    These bonds are created from pools of mortgages and can be backed by government guarantees. They offer higher yields than government bonds.
  • Municipal
    State and city municipal bonds have slightly higher risk than U.S. government bonds. They offer the benefit of being free from federal income tax, although you may have to pay state or local tax and the federal Alternative Minimum Tax.
  • Corporate
    Generally, corporate bonds have higher risk than government bonds, but usually offer higher yields to offset the additional risk.
  • International
    Issued by foreign governments or corporations, these bonds can diversify your investments but have the added risk of foreign currency fluctuations and potential political instability.
  • High Yield
    Lower quality bonds issued by corporations and municipalities may pay higher interest because of a greater risk the issuer will default.

Bond Prices and Interest Rates

Until a bond matures, it can be bought or sold on the open market. If it changes hands before maturity, the price can fluctuate depending on interest rates at the time. When interest rates fall, bond prices rise and vice versa.

Let's say you buy a $10,000 bond earning 4% interest. Three years later, similar new bonds cost $10,000 and earn 6% interest. No buyer would pay you $10,000 for your bond paying only 4%. You'll have to offer it at less than you paid if you want to sell it.

However, if new bonds selling for $10,000 offer only 3% interest, you'll be able to sell your 4% bond for more than you paid. Buyers generally will pay more to get a higher interest rate.


Benefits of Bond Investments

  • Diversification
    Bonds can complement stocks in your portfolio because they often respond differently to market events than stocks. However, diversification does not assure a profit or protect against a loss in a declining market.
  • Safety
    While a bond is not risk free, it can protect your original investment if held to maturity. Investing in bonds generally is less volatile than investing in stocks but may offer a lower rate of return than a stock investment.
  • Steady Income
    Bonds make regular interest payments, which can help supplement your income.

IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.

This information is for educational purposes only and not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.