So what is a bond? A bond is an investment that lets the investor loan money to a borrower, with the expectation that you’ll get your money back with interest after your term length expires.
A bond is a fixed income instrument that represents a loan made by an investor to a borrower – typically corporate or governmental.
Furthermore, bonds are one out of two ways you can invest in a business. Another way is to buy a company’s stock. So bonds, in this case, represent a debt investment which means the company owes you money. While a stock represents an equity investment, which means you own part of the company.
Continue reading below to learn more about bonds.
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Table of Contents
How Do Bonds Work?
By buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date. So you can get back and collect periodic interest payments along the way since you’re lending.
Once the bond matures, you’ll get back the money you paid for the bond with interest on top. The interest payment is part of the return that bondholders earn for loaning their funds to the issuer.
So when you’re shopping for bonds, you can see each bond’s price, maturity time and coupon rates. A coupon rate is the annual money you’ll receive, it’s expressed as a percentage of the principal that you pay to buy the bond. Coupon rates for new bonds hover around the market interest rate.
The Bond Market
The bond market tend to fluctuate in the interest rate, but what does it mean? The interest rate for this is set by the Federal Reserve also known as the federal funds rate.
Usually the feds uses its power to buy and sell Treasury Bonds to affect interest rates. So when they sell Treasury Bonds, it takes out money that usually circulates in the economy, in result cash becomes more scarce which makes borrowing money relatively more expensive and therefore raises interest rates.
And the interest rate that the FED decides on affect other other interest rates, including your mortgage rate and the rates on bonds.
When the general interest rates foes up, the price of existing bonds falls, meaning that interest rates and bond prices have an inverse relationship.
If interest rates rise, new bonds that are issued will have a higher interest rate to reflect this change. If you go to sell a bond that has the old, lower interest rates, you’ll have to lower its price to get anyone to buy it.
Risk of Bonds
As with any investment, bonds have risks. This is the risk that changes in the interest rate will make the bonds they hold less valuable, meaning that people are going to sell for less than what they paid them for.
Not only that, bonds come in short-term and long-term forms. So the longer the term of your bond is, the more uncertainty there is about what interest rates will do in the duration. However, if you sell before maturity, the changes in the price of your bond are a problem. If you hold onto your bonds, you’ll get your principal back – unless the issuer becomes unable to pay.
Another risk is a credit risk, it’s when a company defaults leaving bondholders to scavenge what’s left of the company’s assets.
Lastly, bonds are subjected to inflation risk, so when you buy a bond that pays 2% and inflation is at 2.4%, you’re essentially losing money by holding that bond. People often see bonds as a safe investment. But in a low-interest rate environment, the interest that bonds pay might not top inflation rates. It is unlikely to lose your principal if you invest in a safe bond like a Treasury bond, but your money might not be growing.
How to Buy Bonds
You can buy Treasury bonds directly from the US Treasury through its site Treasury Direct. But for other types of bonds, including municipal bonds and corporate bonds, you’ll go through a brokerage.
You can also buy bond mutual funds, bond ETFs and bond index funds. A Bond ETF trades on the market and offers different tax advantages to bond mutual funds, while a bond index fund charge lower fees because they’re passively managed as opposed to actively managed.
Lastly, there are also mortgage bonds, backed by real estate mortgages. Make sure you choose wisely since many mortgage bonds are dependable investments, while others are based on mortgages with a high risk of default.
When you invest in bonds, you lend your money to an organization that needs capital. Bonds as investments are less risky than stocks and allowed to be traded for a higher price. The best time to take out a loan is when bond rates are low, since bond and loan rates go up and down together. For more investment opportunities, check out the latest investment promotions and our other post on more investments.