The biggest advantage of investing in the bond market is security. Bonds are generally a less risky option than investing in stocks. The difference boils down to an investment rule of thumb: Debt is a safer investment than equity. It's one reason bonds pay lower returns on investments than do stocks. Government-backed bonds tend to be a bit safer than corporate bonds, but corporate bonds usually pay higher rates of interest.
What Is the Bond Market?
The term "bond market" refers to the financial market in which people buy and sell debt securities, which usually are government-issued bonds and corporate debt instruments. Trading in the bond market typically is done in the primary market -- in which debt securities are purchased by investors from sellers, who are the borrowers -- and in the secondary market, where investors trade securities that were previously issued. Most bond trading is done over the counter, or OTC.
Types of Bonds
Government bonds are U.S. Treasury securities, including T-Bills, T-Notes and bonds, although T-Bills, because of their short maturity -- less than one year -- aren't technically bonds. Notes mature in one to 10 years and bonds represent debt securities of more than 10 years. U.S. Treasury bonds are considered risk-free, unlike any type of stock. Municipal bonds are securities issued by cities and other municipal governments and, although riskier than Treasury bonds, still are considered safer than equity investments. Cities don't often go bankrupt, but it does happen. Corporate bonds offer a higher risk rate than government and municipal bonds, but interest rates generally are higher. Mortgage-backed securities are another form of bonds based on securitization.
Advantages of Investing
Bonds normally are less risky than stocks. Government entities rarely default, with the U.S. government being considered risk free. Corporate bondholders have priority over shareholders when a corporation pays its bills. In worst-case scenarios like bankruptcy, creditors -- including bond holders -- typically recoup at least a portion of their investments. It's not uncommon for shareholders to lose their entire investment. Credit ratings for municipal and corporate bonds should be closely scrutinized.
Slow but Steady
The very characteristic that makes bonds unattractive to some investors -- slow growth compared to the potential higher returns of stocks -- also serves as an inducement for other investors. A slow but steady growth rate is virtually assured over time with bonds. Although not quite as safe as savings accounts or certificates of deposit --- which are federally insured up to $250,000 per account --- bonds offer an alternative at a higher interest rate. Bonds also serve as a hedge against volatile markets, with guaranteed returns in both bull and bear markets and higher secondary-market selling prices in down times. Bonds serve as a calming portfolio influence when stocks take a hit. Interest rates may be low but they're virtually guaranteed and paid at regular intervals. A buy-and-hold strategy is a conservative approach, but investors receive payments, typically twice a year, and the face value of the bond upon maturity.
Just like stocks, bond investing can be -- and should be -- diversified. Different types of bonds and varying maturity terms can minimize volatility and ensure a steady cash flow. Just like stocks, try avoiding putting all your bond-investment eggs in one basket. Bond funds are another strategy for diversifying.
Bonds offer a relatively safe alternative, or adjunct, to stock investment. Despite some risks with corporate bonds, bondholders enjoy advantages over stockholders. Bond prices, either at auction or through the U.S. Treasury, are much less volatile than stock prices. Bond defaults are rare and bonds, overall, represent an attractive compromise between risk and reward for many people.
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