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A Closer Look at Bonds

Bonds, or fixed-income investments, can offer investors a source of income with generally moderate risk and, when combined with stocks in a portfolio, can help smooth overall portfolio return volatility. Most retirement plans offer bonds, either through bond funds or through a balanced or target date fund including both stocks and bonds. An investment in bonds can be an important component of a diversified portfolio.

Definition of a bond

Unlike a stock, which represents ownership in a company, a bond is similar to a loan or an IOU. With a bond, money is loaned to a company or government entity in exchange for regular interest (coupon) payments, plus a commitment for the return of the full loan amount, or face value, when the bond matures.


Types of bonds

Corporate bonds

Issued by corporations, these bonds can provide an investor with a steady stream of income at a generally higher rate of return than government bonds. Credit risk, the risk that the corporation will not be able to make coupon payments or repay the face value, is generally higher for corporate bonds.

U.S. Government bonds

Bond issued by the U.S. government. Government bonds have lower credit risk because they are backed by the full faith and credit of the U.S. government.

U.S. Government agency bonds

Issued by federal agencies and government-sponsored entities, these bonds are indirect debt obligations of the U.S. government. Examples include the Federal National Mortgage Association, and the Student Loan Marketing Association. Agency bonds have a lower level of credit or default risk than corporate bonds, although these securities are not backed by the full faith and credit of the U.S. Government.

Municipal bonds

Issued by a state, county, city, town, village, or local authority to raise funds for general use or particular public works projects, these bonds are also referred to as "munis." Munis fall somewhere in the middle of the credit risk spectrum, depending on the creditworthiness of the issuer and the type of debt obligation.

Potential benefits of including bond funds in your portfolio

There are several potential benefits to including bond funds — which may invest in a mix of the above types of bonds — in your portfolio, including:

Diversification

When bond funds are added to a portfolio that also contains stock funds, this can help decrease volatility in an investor’s portfolio during market fluctuations. Bond fund and stock fund returns do not always move in the same direction at the same time, and when they do, the volatility of the bond fund can be less dramatic compared to the stock fund. The two asset categories often work together to help lessen the volatility of the overall portfolio.

Professional management

With countless bonds to choose from, you would need a great deal of expertise and time to make decisions around which bonds to purchase and which to avoid. Bond funds are managed by professionals who have the experience and resources to select bonds that match the investment objectives of the fund.   

Liquidity

It's easy to buy and sell shares of a bond fund when the need arises. You don't have to wait for individual bonds to mature. When you sell shares of a fund, you receive the fund’s current net asset value (NAV), which is the value of all the fund’s holdings divided by the number of fund shares, less any redemption fee, if applicable. Therefore it is easier to sell a bond fund rather than a bond investment.

Affordability

Individual bonds can cost as much as $10,000 each—too expensive for many investors. Bond funds typically require a smaller initial investment to get started, greatly lowering the barrier to bond ownership.

Potential risks of including bond funds in your portfolio

While bond funds are generally less risky than stock funds, there are risks to consider when deciding to add bond funds to your investment portfolio, including:

Interest rate risk

A risk common to most bonds is interest rate risk. When interest rates rise, a bond's price will usually drop, and vice versa.

Credit risk

Bonds are also subject to credit risk, which is the risk that the issuer will fail to repay the principal and interest in a timely manner, if at all. When a bond stops paying interest or is unable to repay principal, the bond is in default. This risk is heightened in lower rated bonds.

Market risk

This is the risk that an investor will need cash and have to sell the bond before maturity at an unfavorable price. If sold prior to maturity, bonds are subject to market risk. All bond and fixed income investments may be worth less than their face value if redeemed prior to maturity.

Adding bond funds to your portfolio could help an investor smooth out the volatility of their stock market investments. Take the Risk Tolerance Quiz to learn more about your risk tolerance and to see sample portfolio allocations.