Bonds are loans or IOUs – a kind of debt, but rather than you owning the bank, you play the role of the bank. You lend money to the government, a company, a city, etc. – and in turn, they agree to pay you back in full, along with regular interest payments.
A city might want to sell bonds in order to raise adequate fund to build a new stretch of road or to build a new bridge, while the federal government issues bonds to take care of the finances that are necessary for the spiraling debts the country could be facing.
Investors who are nervous will generally head towards the safety of bonds and the steady income — this is especially true during times when the stock market is increasingly volatile. Younger investors should put aside 15% or less of their investment income for retirement, depending on your goals, age, and tolerance for risk. Bonds are a good way to balance out any riskier stock investments you might have.
How safe are bonds?
That does not mean bonds are risk-free – in fact, nothing could be further from the truth. Some bonds are very dicey. As with all kinds of investments, the riskier the investment, the more you are paid. With bonds, that risk comes in a few different forms.
The first is the probability that the bond issuer will not make the payments as was agreed upon. When the issuer is not as credit-worthy, they will pay a higher interest rate or yield. This is the reason why the riskiest issuers offer what’s referred to as “junk” bonds or high-yield bonds. Those bonds with the best histories at the top of the spectrum are considered investment-grade bonds.
The safest bonds are issued by the U.S. government, and these are known as Treasuries, which are backed by the U.S “full faith and credit,” and deemed virtually risk-free. A Treasury bond pays a lower yield than a bond that has been issued by a storied company, such as Johnson & Johnson.