One way to diversify your investment portfolio is by investing in bonds. When you invest in a bond, financial expert Igor Cornelsen tells me that you are essentially lending the issuer money. In exchange for this loan, the issuer promises to pay you a fixed rate of interest (usually semi-annually) for the life of the bond, and will repay you the face value of the bond at its maturity. It is this twice-yearly interest income that attracts many to invest in bonds. The payments are predictable and the underlying investment (the initial purchase) is safe.
Some of the considerations before investing in bonds include assessing the risk if the bond. Issuers of a bond are credit rated by a number of institutions, the most well known probably being Standard & Poors. As with most investments, the higher the risk, the higher the potential return. Generally accept only the amount of risk you are comfortable with. Bonds are generally less risky investments than stocks since they are less dependent on the supply and demand that drives the stock market. However, their price does fluctuate depending on a number of factors such as the maturity date, interest rate, redemption features and tax status.
Interest rates are typically paid on a fixed, or coupon, rate. This rate is stated and does not change over the life of the bond. For example, the interest rate on a $1,000 bond may be 6% per year. In this example, the bondholder would receive $ 60 per year until the bond matures and then receive the initial $1,000 back.
Sometimes the issuer prefers to have a variable rate. These rates change periodically and are usually tied to some third-party benchmark such as the LIBOR (London Interbank Offered Rate). A third type is a zero-coupon bond. The bond issuers of this type of bond do not make any interest payments over the life of the bond. Investors of these bonds buy them at a discounted amount and receive the face amount at the bond’s maturity. For example, a bond may be sold at $5,000, but at its maturity in twenty years be redeemed for $20,000. An important consideration for purchasers of zero-coupon bonds is that even though the interest is not paid out until maturity, it is taxable as it accrues.
A bond can be redeemed under several methods. A call provision basically means that the bond issuer can redeem the bonds at any point for a set price on a particular date. This may happen if the market interest rates fall below the bond’s interest rate. A put provision means that the bondholder can redeem the bond on specific times at set prices during the life of the bond. Bonds with a conversation option means the bond issuer can convert the bond to common stock.