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When you buy a bond, you are making a loan to the issuer. In return, the company or government agrees to pay you a fixed amount of interest, usually twice a year, until the bond matures. At that point, you are paid the bond’s face value.
For example, let’s say you buy a $10,000 bond with a 4% interest rate (called the coupon rate). Each year, you would receive $400 in interest, in two, $200 installments and, at maturity, you’d get back your $10,000. You can sell the bond to another investor before it matures.
Bonds aren’t without risk—mainly from interest rates. The bond market thrives when interest rates fall.
For example, a bond paying 5% interest that was issued last year will be more valuable today if new bonds are paying only 4%. So if you paid $1,000 for your bond, you could probably sell it at a premium. For example, your $1,000 bond might be worth $1,250 to another investor. That’s because an investor would have to invest $1,250 at 4% to earn as much interest as you’re earning on your $1,000 investment at 5%.
The reverse is also true. When interest rates rise, bond values drop. You could lose money if you had to sell lower-yielding bonds.
For example, if you bought a 30-year bond yielding 5% and new bonds jumped to 6%, your bond would be worth about $833.
If you held the bond to maturity, such price swings wouldn’t matter. You’d still earn 5% annually and you would receive the full value of the bond when it comes due.
Over the long term, the performance of both corporate and government bonds has lagged the stock market. If stocks are too unsettling for you, or if you have fewer than ten years until retirement, you may want to add modest amounts of bonds or other fixed-income vehicles to reduce the overall risk level of your portfolio.
(Your employer-based retirement plan may offer a stable-value investment option, which acts like a bond but includes insurance to provide a guaranteed rate of return.)
Although investing a portion of your assets in bonds may reduce your overall rate of return, the additional diversification and safety may make for a smoother ride toward retirement.
*The information on this page is credited to IPT and Kiplinger. Their original materials are made available on the Kansas Securities Commissioner's website.
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