What is a Bond?

We hear about bond rates and markets in the financial news, but what exactly is a bond, and are they worthy investments?

Stocks and bonds get lumped together all the time, but the truth is, they are very different investments. While you can lose money in stocks or gain nearly unlimited amounts, a bond is usually a fixed-income investment. It is, in essence, a loan with defined terms, including the interest rate and the maturity date.

The most well-known of these are from the U.S. Treasury. Treasury bonds, or T-bills, have two moving parts: the price and the yield. Presumably, an investor can buy a $10,000 T-bill and lock in an interest rate of 3.2%. (We’re using 3.2% as an example. However, the interest rate can change throughout the day.) Once you make your purchase, the price changes a little bit every day, but it’s guaranteed to be worth $10,000 upon maturity. The average investor does not need to stress out over the price fluctuations. If you want a bond, but don’t want to hold it for more than three years, then you just buy a three-year bond. It’s a fairly straightforward transaction.

As you can see, of course, your gains are tied closely to the interest rate. However, some investors use a bond ladder strategy to limit that risk.

Bond ladders are a way of creating your own adjustable-rate income stream, by buying a series of bonds with staggered maturity dates. Then, as each security matures, you reinvest the proceeds in a new security at the top of the ladder, which becomes your new longest-dated security. If interest rates are rising, the new investments will have higher coupon rates than the investments rolling off the bottom of the ladder, and your yield will gradually rise.

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