Bad Ian Fleming reference aside, the prime function of a bond is that you are loaning money to a corporation for a fixed timeframe, and getting a fixed rate of return on your money. This is called the coupon rate and is based on the original capital invested. The payoff is figuring out how much of your investment portfolio should be in stocks vs bonds.
If you’re interested in investing in bonds, which type should you choose? Investing in bonds can take many forms, but the key to understanding the bond markets is that when you buy a bond, you are lending someone money, be it a company or a government.
The key advantage of bond investing is that they’re rated in their risks. The bond has a term where it pays off (for example 10 years) at which point you get your initial investment back. Bonds will pay a steady income of whatever their rate of return is, taken as a percentage of the initial investment. Thus, if you invest $100,000 in a series of bonds that return interest at a coupon rate of 3.5%, each year, you’ll receive $3,500 of interest income. The big advantage of bonds is their steady income stream. Add to that you get the initial investment back when you’re done.
So, what’s a good investment strategy for bonds? It depends on the type of bond you are buying. Short term (less than five years) bonds tend to have lower coupon rates, but have the advantage that your assets aren’t periods of time. A mix of short term bonds means that if an emergency strikes while you’re enjoying retirement, you’re very likely to have a bond maturing to give you an immediate lump sum of cash. Medium term bonds tie your money up for longer stretches of time (typically more five to seven or ten years.), while long term bonds tie your money up for 10 to 30 years or more. The coupon rate will also vary with the credit worthiness of the company the money is lent to; lower credit ratings result in higher coupon rates, and the highest credit rating is typically governmental bonds; this is one reason why the 30 year Treasury bill (or T Bill) is used as a baseline bond metric.
There’s more to investing money in bonds than the coupon rate. Since bonds can be bought or sold at any time, very few people hold bonds to their full maturity, and bond funds keep portfolios of bonds with different maturity rates. In general, when the interest rate goes up, the price of an existing bond goes down, because buying a new bond at the higher rate gives a higher rate of return. When the interest rates go down, the bond price of an existing bond goes up, because it gives a higher rate of return than a newly purchased bond would.
