Whether you’re new to investing or you’ve been investing for years, chances are you are you’ve heard of bonds, but you may not know exactly what they are. While they’re generally considered a stable investment and an important part of a diversified portfolio, it’s important to understand how bonds work before investing your hard-earned money in them. Planning Made Simple not only helps to answer the common question of what bonds are but explores some of the important facts to consider.
How Do Bonds Work?
When you invest in a bond, you’re loaning money to the bond issuer for a set time – usually several years – at an agreed-upon interest rate. At the end of that period, also called the maturity date, your principal (the amount you loaned) will be repaid to you in full (unless it was called early). Until then, bonds pay periodic interest payments on your investment at predetermined intervals. Typically this is twice a year for corporate bonds until maturity, and payment continues until your principal is repaid with any remaining interest due upon maturity.
Types of Bonds
Bonds come in all shapes and sizes, with different terms and maturities. The most basic type of bond is a government bond – also known as treasury security – issued by the federal government or its agencies. These offer some of the lowest risk investments available since the full faith and credit of the U.S. government backs them. Companies issue corporate bonds; state or local governments issue municipal bonds; and quasi-governmental organizations like Fannie Mae or Freddie Mac issue agency bonds. Bond rating agencies will classify bonds or treasury notes that are issued by entities that have a top credit rating and a strong history of reliability as investment-grade bonds.
A government bond is a debt obligation governments issue to finance operations and pay off existing debt. They generally come in two forms: nominal bonds (sometimes referred to as treasury bonds) and indexed bonds. Nominal bonds offer investors a fixed interest rate over the duration of the bond, while indexed bonds are tied to inflation or other economic indicators. The bond terms depend on the country it was issued, but most have maturities ranging from one year to 30 years.
When you purchase this type of bond, you are essentially lending money to the bond issuer in exchange for a promise of repayment with interest at some point in the future. It is important to note there is no secondary market for government bonds; once you buy one, you must hold it until maturity unless you can find someone willing to buy it from you directly at its current market price (which may be higher or lower than what you paid).
Municipal bonds come in two main varieties: general obligation (GO) bonds and revenue bonds. GO bonds are backed by the full faith and credit of the issuer—usually a state or local government—and are generally considered safe investments because they have guaranteed repayment. Revenue bonds, on the other hand, are secured by the revenue generated from a specific project funded with bond proceeds—for example, toll roads or airports. Revenue bonds are riskier than GO bonds but may offer higher yields.
The primary benefit of investing in these types of bonds is most state and local governments do not pay federal income tax on the interest earned from these investments. This means investors can earn tax-free interest income if they purchase them within their state. Furthermore, many states exempt muni bond interest from state and local taxes as well—this is known as double tax exemption. For this reason, many investors choose to incorporate a municipal bond to diversify their portfolios while receiving attractive tax benefits.
Agency bonds are debt securities issued by government-sponsored entities (GSEs) such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The U.S. government created these entities to improve access to credit for homeownership and other purposes. As a result, they have an implicit guarantee from the federal government. If they cannot meet their obligations, the federal government will ensure investors receive their returns.
There are two types of agency bonds: short-term and long-term. Short-term agency bonds generally mature in one year or less and offer a lower interest rate than long-term agency bonds because of their shorter maturities. Long-term agency bonds typically have maturities over ten years and offer higher interest rates due to longer time horizons.
A corporate bond is essentially a loan taken out by corporations from investors. In exchange for lending money to the corporation, investors receive interest payments on the bond and the principal when the bond matures. When a company issues a corporate bond, it agrees to pay back its debt in full at the maturity date. This repayment promise is called the “bond indenture” or “bond agreement” and outlines all of the details regarding payment terms and conditions.
The price of corporate bonds can fluctuate depending on changes in market interest rates, the credit quality and risk of the issuer, investor sentiment toward credit risk in certain industries or sectors, and other factors affecting demand for bonds, such as geopolitical events or economic news. As interest rates go up, so do bond prices; conversely, when interest rates fall, so do bond prices. Therefore, investors need to understand how changes in market dynamics affect their investments to make informed decisions about when to buy or sell their bonds.
Advantages & Disadvantages of Bond Investments
The main advantages of investing in bonds include relatively low risk compared to stocks and steady income from interest payments during their term. On the other hand, if inflation rises faster than expected, fixed-rate bonds lose value over time because their fixed incomes become less valuable relative to increasing prices for goods and services. There are treasury inflation-protected securities that can be used as a hedge against rising inflation. Also note if interest rates rise higher than what was offered on your bond when purchased, newer investors can have an advantage since they can buy bonds with higher yields than those already owned by investors who bought earlier at lower yields.
Understanding how bonds work for bond investors is key to making informed decisions about investing in them. There’s no one-size-fits-all solution for investing and the different types of investments available. Each asset, whether bonds, mutual funds, or something else, offer different benefits depending on individual needs and goals. Knowing how each type works can help you as an investor make better decisions when determining where your money should be placed for maximum returns without taking on too much risk. For new investors looking for steady income over long periods with minimal risk involved, investing in bonds can be an ideal solution.