Varying your usual daily routine can add a little bit of flavour into your life, and sometimes that is just what you need.

Adding bonds to your portfolio of investments, likewise, is a great idea if you are looking to add the benefits of diversification and enhance the rate of return on your money while reducing the risks.

1. What are bonds?

Bonds are a financial contract with a pre-specified rate of return. They are like an IOU – either issued by a business or a government.

As an investor your money goes to the bank or business and they promise you a rate of interest and to return the full amount of your original investment at a pre-specified date in the future.

Bonds are also commonly referred to as fixed income investment or fixed interest investments, because they pay a fixed rate of return.

There are two main types of bond, government bonds which are known as gilts, and corporate bonds which are the ones issued by companies.

2. Why you should invest in bonds

The main reason that investors add bonds to their portfolios is to add variety. By diversifying your investments, you reduce the risk and improve the chances of a better return on your money.

Keeping a mixed portfolio that includes bonds, stocks and cash as a base of investments is a good idea; if there is a downturn in a segment of the market you do not lose all of your wealth in one go.

Bonds normally pay interest semi-annually, which means they give you a predictable income return.

Bonds are also a good choice if you are looking for your original investment to have a high chance of being fully protected.

Bonds are a good investment choice for long term investing, such as for your retirement or for a new home later in life.

3. How do bonds benefit you?

Whatever your financial goals, investing in bonds is a good choice that will help you achieve your objectives.

Investing in bonds has a lower risk than investing in stocks and because of this lower risk, they give you a lower level of return.

4. Common risks of investing in bonds

Government bonds, or gilts, are normally the safest type of bonds. This is because governments are less likely to fail to repay your capital or fail to pay your interest.

If the party that issues the bond does this they are said to “default on their debt”.

This is the biggest risk of buying bonds and applies more so for corporate bonds. These are riskier than government bonds but still lower in risk than equity markets.

Corporate bonds are issued by companies and corporations which means that if their business goes bankrupt you might not get some or even all of your money back.

Although this is unlikely to happen, if it did you will still get your invested money back before the shareholders do.

5. How do you buy a bond?

The key reason to purchase bonds is to diversify your portfolio. You can buy almost any bond at your brokerage or local bank.

Brokers charge a small commission or they may mark up the bond price instead – clarify this with your broker before confirming that you want to buy.

6. Junk and convertible bonds

Government bonds are issued by national governments. Corporate bonds are issued by businesses.

High-risk/high-yield fixed income bonds are known as junk bonds. These bonds may promise you a high return but in exchange you are facing a correspondingly high risk of losing your money.

A convertible bond gives you a financial performance that works as a bond in certain market conditions and is similar to a bond in other market conditions.

It is more versatile in giving you a return so it can be more expensive than a standard fixed income bond.

7. Bond ratings

The financial marketplace has a system of credit ratings so you can better understand which bond is riskier and which is safer.

Bonds rated AAA to BB are known as investment-grade bonds. These are less risky and are normally issued by larger, blue-chip companies and governments.

With these you have a higher likelihood of receiving your initial investment and interest payments in full and on time.

On the other hand, fixed income bonds rated BB to D are known as high-yield bonds or junk bonds. These pay a higher rate of interest but are also a much riskier investment.

This article first appeared in The New Savvy.

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