Bonds (and Bond Funds)

Have you ever loaned money to a friend? Companies, governments and other organizations borrow money all the time - through bonds.

A bond = a long-term I.O.U, a promise that money will be repaid within a given period of time.

Example — A 10-year bond issued by the Ford Motor Company paying a 7% annual interest rate. You pay $1,000 (the "par or principal value") when the bond is issued, i.e., you lend Ford $1,000. You receive $35 in interest from Ford every six months ($1,000 x 7% = $70 per year or $35 every six months; 7% is the "coupon interest rate"). After the 10-year period (the bond's "maturity"), Ford pays you back the $1,000 you lent it.
 
Buying Bonds — You can buy (and sell) bonds directly through brokers, but most people invest in bond funds. Bond funds are run by professional investment managers who pool many people's money so they can buy large amounts of bonds at lower cost and spread the risk.
 
Selling Bonds — You may decide to sell your bond before it matures. The value of your bond (or bond fund) will depend on how much buyers are willing to pay for it - and that usually depends on the interest rate being paid on other, similar investments when you're ready to sell. Why isn't a $1,000 bond always worth $1,000 after it's first issued?
Because market interest rates — interest rates you can get today for a similar type of investment — change all the time. When market interest rates are higher than your bond's interest rate, your bond becomes less valuable, because buyers could get better interest by buying a new bond instead of yours. But the reverse is true as well.
 
Here are some other things to remember about bonds:
  • Bonds (and bond funds) don't protect the value of your savings against inflation. If the cost of living is higher than the fixed interest rate, you're losing money. For example, if your bond pays 4% interest and inflation is at 5%, you're losing 1% a year.
  • Bond prices don't move around as much as stock prices. Also, when the value of stocks goes up, the value of bonds often goes down (and vice versa). Why? Because when the stock market is strong, investors see other investments as more attractive than bonds - so bond values go down. Bonds (and bond funds) provide a good way to balance your investments in stocks (and stock funds) - and lower the risk.
  • Bond funds do not pay out coupon income or the face value of individual bonds held in the funds' portfolios. Rather, bond funds price bonds daily and add any coupon income received to the net asset value for the fund. When you redeem shares of a bond fund, you receive the net asset value of those shares similar to how you receive the value of a share of stock if sold.