This week I decided to write about bonds due to how common the term may be in investing conversations. Whether in a discussion with your financial advisor or at the dinner table you have probably heard of a bond. Similar to stocks or mutual fund a bond is another form of investment that can be held within your investment accounts. The formal definition of a bond is a fixed income instrument that represents a loan made by an investor to a borrower. They can be either government or corporate in nature and typically do not provide a high yield. Bonds can help to diversify many portfolios. They tend to move in different directions than stocks although they can be negatively affected just like stocks can but typically face less volatility providing more security to your investments. With the security on investments comes the lack of ability to significantly increase your money. Similar to stocks also it is important to invest in bonds in different asset classes in order to further diversify your portfolio.
Understanding how bonds work can be difficult to understand. A very simplified explanation is that when a company needs funds they may issue bonds to investors. These investors are given the terms of their agreement and are given interest payments for their money. At the provided maturity date the bond can be redeemed.
There are many different factors that affect bond prices. One of the many conversations you may have heard bonds come up in are discussion centered around interest rates. Interest rates affect the value and income that can be achieved through bonds. Bonds move in the opposite direction to interest rates. If interest rates go up, bond prices go down. The change is usually not one to one either. In the current climate with interest rates as low as they can possibly be a 1% increase in interest rates could have as large as a 7% decrease in bond values. A second factor is credit quality. Credit quality directly affects bonds, bonds with lower credit quality tend to be more volatile but provide higher interest rates. Liquidity is the final factor that we will be discussing. The liquidity of a bond is defined by how easily it can be sold, lower credit quality bonds have less liquidity which can only negatively affect the price of the bond.
Gaining an understanding of all types of investments is essential especially because the market is ever changing. Due to peoples risk tolerance becoming significantly more conservative during and after the pandemic the shift has been away from futures and more towards investments that provide a more guaranteed return. Bonds and GICs have become more popular especially with people owning substantial assets due to their lack of volatility and security. Although not yielding a significant amount the security that comes with knowing how much money you have at all times can often be worth a fortune.
For more personal finance information make sure to check out Instagram @therichcollegestudent. If you have any suggestions for topics make sure to leave them in the comments and leave a like if you enjoyed reading.