Bonds are how the government and corporations support the creation of money - basically, a big I.O.U. from an institution to the investor. Buying a bond is like giving a loan. In return for the money, the institution promises to pay the investor a specified interest during the life of the bond and to pay the original amount, or principal, when the bond reaches maturity.
Bonds are less risky than stocks because they are less susceptible to market pressure. The value of stocks rises as the value of the corporation rises, so the returns are uncertain. In selling bonds, however, the institution is obligated to pay the returns. Although they are less risky, bonds also have a lower rate of return over time.
There are so many differing kinds of bonds that the Commerce School offers a complete 14-week course covering introductory bond differentiation. For the purposes of overview, however, it suffices to say that, in general, there are only two different kinds of bonds: government and corporate.
Government issued bonds can be divided into three kinds: short-term treasuries (T-bills), government notes and government bonds, which are differentiated based on their maturity date. For example, T-bills reach maturity in under a year, notes between one and 10 years and bonds over 10 years.
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Government issued bonds are less risky than corporate bonds because the government is protected against default risk. Default risk occurs when a company files for bankruptcy and reneges on the bond promise. The only way that an investor would be prevented from collecting returns would be if the federal government itself declared insolvency.
On the other hand, corporate bonds, mortgage-backed securities and asset-backed securities are riskier, but they have a higher rate of return. Corporations often are rated in terms of their credit quality, which is an assurance of financial stability. Bonds sold by companies with the lowest credit quality are termed "junk bonds," meaning they are the most likely to default on the bond. Such bonds, however, usually have the greatest rate of return.
While allocating funds to bonds is a function of an investor's aversion to risk, older investors should have a larger portion of their portfolios invested in bonds, Finance Prof. Lawrence Kochard said.
"Returns can be recouped by someone in their twenties by earning more in salary over the years and waiting over a long period of time until the equity markets recover," Kochard explained.
"A general rule of thumb is to divide your money between bonds and stocks according to your age," Finance Prof. Patrick Dennis said.
That is, a 20-year-old should keep about 20 percent of his or her portfolio in bonds.
At this point, young investors might be wondering why they should invest in bonds at all. To that question, both Dennis and Kochard agreed that diversification is critical to maintaining a stable income.
"Diversification is the key to avoid taking a loss on any one bond, as well as stock," Kochard said.
Like stocks, bonds can be bought through mutual funds, which trade in both government and corporate stocks.
"Government bonds can be bought online, and corporate stocks over the counter, but that's complicated for the individual investor," Dennis said.
A good place to start investigating bonds is online. Investinginbonds.com provides an easy-to-understand overview of what a bond is, and how to go about the process of investing. An investor who already has decided to add bonds to his or her portfolio can visit the Vanguard Group (www.vanguard.com) to create an account and examine the options available to individual investors.
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