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Bonds can be used as a "core" investment to build the foundation of a balanced portfolio. This is because they offer a wide range of maturities, interest payment terms and credit quality ratings selected to fit most portfolio needs.
When you invest in a stock, you become a part-owner of a corporation. Your equity holdings have unlimited upside potential and downside risk. A bond investor is not an owner but a creditor of the underlying company or government entity. In effect, you are lending money to a company or government (the "issuer") when you purchase a bond.
It is the obligation of an issuer to pay its bondholders periodic interest at a fixed rate (the "coupon"), and to repay the amount of the loan (the "principal") at a specified time in the future (the "maturity date"). Because bonds are debt obligations of the issuer, bondholders have a senior claim over stockholders on a company's assets, should they be liquidated.
| | | | | Three bond investing concepts | | |
| 1. |
Bonds are a promise to return principal (par value) at a set maturity date.* This enables you to time the return of principal to meet your future financial needs. You know the issuer is obligated to return your principal when you hold your bond investment to maturity. *Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs) return principal over the life of the investment and have estimated maturities that can change. |
| 2. |
Prior to maturity, bond values and interest rates have an inverse or opposite relationship. When interest rates go up, the market value of a bond goes down, and when interest rates go down, the market value of a bond goes up. However, as stated in the previous concept, principal is to be returned when an investment is held to maturity. |
| 3. |
In general, the longer a bond's maturity, the higher its yield. Longer-term bonds are exposed to more market volatility and price fluctuations prior to maturity than shorter-term bonds. Thus, typically long-term bond investors are compensated with higher yields in exchange for this market risk exposure. |
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