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December 2023

Investing Basics

What is a bond? And why buy them?


Written by
 
James S. McConnel

Portfolio Manager

Having played a relatively understated role in investment portfolios for many years, bonds are currently getting some well-deserved attention with the rise in interest rates. Let’s allow bonds, for a moment, to take center stage.

A Bond Defined

Bonds can be labeled, quite simply, as “debt,” but the bond market is also commonly known as the “credit” market – or the “fixed-income” market. Essentially, a bond is a loan that an investor makes to a borrower, who is also called the issuer.

The issuer of a bond is often a corporation, government, or municipality. When buying a bond, an investor effectively loans money to the issuer on agreed-upon terms – typically in return for periodic, stated interest payments (i.e. coupon payments) and a promised repayment of principal when the bond “matures” years later.

The interest payments a bond investor receives are generally taxed as ordinary income. But bonds issued by governments and municipalities can be “tax-exempt,” with special rules making their interest payments completely tax-free in some cases. For investors in high tax brackets, tax-exempt bonds can sometimes be particularly attractive, even if they have a lower “coupon” than a taxable bond.

When an investor buys a corporate bond, the investor does not obtain ownership rights to the underlying company like a stockholder does. He or she simply obtains a promised stream of income over a stated period of time based on the coupon or interest rate on the bond.

The value of a bond can change over time as the demand for that bond changes in the secondary market (due to changing interest rates or the credit quality of the issuer). But bond prices do not typically fluctuate as wildly in value over their lifetime, as stock prices might, unless an issuer falls into bankruptcy. As long as the investor holds the bond until maturity and as long as an issuer can repay its debts, a bond should mature or revert to “par” with a return of principal.

Because bond payments are prioritized by corporations over stock dividends – and because bond owners are repaid in bankruptcy before stockholders – bonds are typically considered safer, less risky investments than stocks.

Why Invest in Bonds?  

While bonds may not grow meaningfully in value over time, like stocks, they can nonetheless provide a reliable source of income. At Mitchell Sinkler & Starr, we normally recommend that investors buy bonds only from issuers that can demonstrate a high credit quality (i.e. “investment-grade bonds”). Bonds from large, established companies, government, or municipal entities provide a dependable source of income, and they can be laddered in a way to generate repayments of principal over a number of years. Because bonds represent a different asset class than stocks, they typically provide diversification and stability to a portfolio. And when interest rates are high, the yield on bonds can make them an appealing alternative income source to dividend-paying stocks.

 

James S. McConnel

 

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