What are Bonds?
You have probably heard people talking about bonds, or read about them and how much one can earn if they invest in bonds but you really do not know what bonds are or how they work. We shall take you through all these and enlighten you.
Bonds are debt securities or debt investment whereby, if you buy a bond, you are actually lending your money but with security. It is a way for you to invest your money by lending it. Borrowers will issue bonds so as to raise funds from investors and most of the funds are usually used as capital for further ventures or expansion. Some of the entities that issue bonds are governments, corporations, municipalities and other federal agencies.
The entity that issues the bond is known as the Issuer and when you purchase one, you will get paid at a specific interest rate for the period in which the bond goes for. If the bond goes for 10 years for example, then the life of that bond is 10 years and you will be paid interest amount each year while you will be paid back the principal amount; which is the initial amount of money you paid for the bond. You get your principal amount at the maturity of the bond which is when the duration of the bond ends.
The name bonds include bills, debt securities, and notes. Bonds offer investors a safe but secure way of investing their money rather than have it sitting in a bank or invest it in a risky venture. Bonds are bought for a specific period of time and they can be at either a fixed interest rate or variable interest rates. As an investor, you general make money from bonds through the interest you earn and this is either paid annually or semi-annually in most cases.
However, you can also make money by selling a bond that you own before its maturity time. You will get paid more money than you originally paid for the bond and you still get to keep the interest that you will have earned at that particular point in the life of the bond.
Types of Bonds
There are different types of bonds varying in the amount of time they take for maturity, the amount one has to invest and the level of risk involved. One should consider all these factors before they settle on one type of bond to invest in. You can also choose to invest in more than one bond so as to increase your income.
- Foreign bonds
These are bonds that are issued but are based on a foreign currency. For example, one government can issue a foreign bond in another country and therefore it will use the currency of the country where the bond is issued. Some foreign bonds will generally use the American dollar as the currency of choice. Although the issuer will still pay interest periodically as agreed, this type of bond is greatly affected by the exchange rates as it can affect how much one makes or has to pay. Hence when buying a foreign bond, not only should you consider the interest rates but also consider the exchange rates.
- Treasury bonds
Treasury bonds are bonds that are issued by governments and the main purpose is to finance budget shortfalls. These type of bonds are generally secure because the issuer is the government, which has a lot of financial power and will have no problem paying back, however, this security further brings a disadvantage because generally, these types of bonds have very low returns compared to others. The interest rates are usually low and taking in mind that taxes are levied on the interest income, you can end up making very little money.
- Corporate bonds
Corporate bonds as the names suggest are issued by corporate entities and companies. These bonds will normally have returns that vary with some having moderate returns and others offering high returns. However, corporate bonds tend to be risky as compared to treasury bonds.
For this type of bonds, you can have high yield bonds that will have high returns, but the key thing to look out for is the performance of the company, not only as an individual company but as an industry as a whole. You should know as much as you can so as to make an informed decision regarding whether the risks involved are acceptable because the ability of the corporate entity to pay interest will depend on performance.
During harsh economic times, these bonds perform worse that treasury bonds even though corporate bonds normally offer higher returns during normal or flourishing economic periods. All these are factors to consider before you purchase a corporate bond.
- Agency bonds
Agency bonds are bonds that are issued by government agencies. Although government agencies are part of the government, they can issue their own independent bonds so as to fund various projects that they run or to come up with extra money in case there are budget deficits. Agency bonds are more secure and have fewer risks involved compared to corporate bonds, however, they offer fewer returns in comparison.
Although agency bonds offer lower interest rates compared to corporate bonds, they offer higher interest rates than those offered by treasury bonds. They are a good investment choice due to the higher returns as well as the fewer risks involved. Interest from such bonds are taxed by the government and this may reduce the amount of money that you end up with hence one should consider this when deciding to purchase agency bonds.
- Municipal Bonds
Apart from the federal government issuing bonds through the treasury, state governments or county governments can also offer bonds so as to come up with more money. These bonds are low risk but also offer low returns compared to corporate bonds. However, they have higher returns than treasury bonds and some will even have a tax waiver to enable the investors to earn more money.
Advantages of bonds
Bonds offer various significant advantages in comparison to other investment options available. Consider these when you are thinking of investing and you may realize that investing in bonds may be the best way for you to invest your hard earned cash.
Bonds are a safe investment option compared to other types of investment and although there are some risks involved, generally there are measures to mitigate the risks. For corporate bonds, in case the company is unable to pay interest as well as the initial investment, the law permits the sale of the company’s assets so as to enable the investor to recover their investment plus interest accrued and this acts as a safety net for investors.
Bonds will attract interest which is paid periodically and regularly hence the buyer gains by having a regular source of income within the life of the bond.
If you purchase a bond and then during the life of the bond interest rates go down, you are still entitled to receiving interest charged at the higher rates. This protects the investor in instances where interest rates go down.
In case an investor views the bond as no longer profitable or due to other reasons is no longer interest in keeping the bond, one can look for a buyer and sell the bond. Although this is not easy, it gives the investor an opportunity to get rid of the bond and walk away if they so wish and they will still make money from their initial investment.
Apart from being an investment, bonds are a great way of saving money because, instead of having your money idle in a bank, you can invest that money in bonds and you are sure that you will get your money back after the bond life-period expires. Therefore, instead of putting money in a bank for ten years, you can purchase a bond that will last for ten years. At the end of it, you will not only have your money but you will also have made money through the interest charged.
Disadvantages of bonds
Bonds do have great advantages but they also have some disadvantages compared to other forms of investments.
High taxes are charged on the interest payments from bonds than most of the other investment incomes. Therefore this will affect how much you end up with as interest because what you get is what is left after the taxes have been deducted.
Bonds may have low-risk factors; however, they also have lower returns if compared to other investments such as stocks. This means that if you are going for high returns in a short time then bonds are not the best option.
If you buy a bond when interest rates are low, even if the interest rates go up, you will still get your interests calculated at the low rates rather than being revised to the high-interest rates. This, therefore, means that you are stuck at earning using low-interest rates no matter how high the interest rates rise.
The interest you an investor earns from bonds are mostly paid either once a year or twice a year in most cases. This means that if you are looking for a more regular source of income as an investment, then bonds would not be great for you unless you find bonds that pay off interest more regularly.
Bonds are generally a great investment choice for those who seek low-risk and long-term investments where they can put their money and earn regular income while still be sure that they will get their initial investment back. Bonds offer a great opportunity for those who have retired, hence have limited source of income to invest and therefore need low-risk investments.
They are also a great option for conservative investors who do not wish to put their money in other forms of investments. However, even if you are a high-risk investor, you can still go for bonds as the offer you a great opportunity to safely diversify your investments and ensure that you get regular payments. You can use bonds as a way of saving money for the long term.