What Are Bonds And How Do They Work?
Stocks, bonds, and real estate are commonly referenced as the three basic pillars of the investment world. We’ve written previously about common stock vs preferred stock, and also about the relative value of real estate vs stock as investment vehicles. But what about bonds?
Those new to investing often make the mistake of assuming that because stocks and bonds are frequently mentioned together, that they are similar financial instruments. This is absolutely not true. Stocks and bonds are very different types of investments, and as an investor it is critical that you understand the difference before handing over your money.
What Is An Investment Bond?
The simplest way to explain a bond is that it is a type of loan. Companies and governments issue bonds as a way to raise money. In exchange for lending a company or government money, investors that buy the bonds are paid interest on the loan.
Every bond has four main components:
Par Value: The loan amount or purchase price of the bond. If you pay a thousand dollars for a bond, it’s par value is a thousand dollars.
Coupon Rate: The interest rate of the bond. The coupon rate is set before the bond is issued and does not change during the life of the bond.
Coupon Date: The frequency at which interest income will be paid. This may be annually, biannually, or quarterly.
Maturity Date: The date the bond expires and the principal amount must be returned to the investor. Maturity dates can rage from a few years to a decade or more from the date of issuance.
How Investment Bonds Work
To illustrate how a bond works, let’s say you purchase a bond issued by IBM. IBM wants to raise money to expand their operations and issues ten billion dollars worth of bonds to help fund the expansion.
The bond you purchase has a par value of a thousand dollars. The coupon rate is 2.5% and the coupon date is biannually (every six months). Finally, the maturity date is in ten years.
So now every six months for the next ten years you will get a payment of $12.50 (2.5% of $1000 is $25, divided into two payments) sent to you by IBM. When the bond reaches maturity in ten years, IBM will give you back your initial investment of $1,000. You will have earned a total of $250 in interest over the life of your investment.
Who Issues Bonds?
There are three common types of bond issued that all investors should be familiar with:
Government Bonds: These are bonds issued by sovereign governments. In the United States, this would be things such as U.S. Treasury bills, bonds, and notes. All of which are backed by the full faith and credit of the country, including the power to tax in order to meet its constitutionally required obligations.
Municipal Bonds: These are bonds issued at the state and local government level. These are often used to fund local or regional projects and typically require voter approval before being issued.
Corporate Bonds: Bonds issued by corporations and other commercial enterprises. While corporate bonds often have higher coupon rates than government or municipal bonds, the income an investor receives from them is taxed at a much higher rate as well.
Are Bonds Right For You?
The world of investment bonds is just as complex and potentially risky as the stock market. Many new investors assume that bonds are safer than stocks because that’s been the conventional wisdom for decades.
The best way to approach any new investment is to speak with an experienced financial planner beforehand and discuss your financial goals first. Based on your goals and tolerance for risk, bonds might be a good option for your portfolio, or there may be other investment opportunities that are a better fit for your needs.
To learn more about investing in bonds and get a free financial planning consultation, please contact our office today.
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