Bonds are a type of debt-based security that’s issued by a government or a company, in order to finance its operations. In other words, a bond is a loan made by the investor, to the organisation issuing it. This bond entitles the investor to an interest rate payment, known as a coupon, throughout the duration of the bond, as well as the ability to sell the bond on the open market to others whenever the investor in question chooses to do so. At the end of the term, also known as the bond’s maturity, the issuer of the bond must pay back the initial amount.
Bonds are usually considered relatively safe investments when compared to other assets like stocks. But this depends on the type of bond. There are different qualities of bond that relate to the credit-worthiness of the institution that issues them.
You may have heard of the term “junk bond” in the financial media. Junk bonds are basically bonds issued by an organisation that has been given a low credit rating by a credit rating agency like Standard and Poor’s. This is a signal to investors that the possibility that the organisation will default on its obligations is higher than in the case of other, higher-rated bonds.
The benefit of holding bonds in a portfolio is that they are considered much safer than stocks, but unlike holding cash, they benefit from the yield of the coupon payment. Longer term bonds tend to have a higher coupon because of the opportunity cost of having your capital locked up, but, as we’ve seen above, this is also true when the issuer has a lower credit rating (i.e. it’s a riskier investment).
A traditional “set it and forget it” portfolio for US investors has been the 60/40 portfolio, in which 60% of an investor's capital is invested in stocks for the opportunity that arises in that particular market, and 40% is invested in bonds for the relative safety, as well as the yield.