A fixed-income instrument bond is a debt an investor gives to a borrower (usually corporate or governmental). Bond investors anticipate receiving regular interest payments and total return on the borrowed funds, just like when you take out a personal loan.
Many investors value bonds for the consistent income they give through these interest costs and the relative safety they offer compared to stocks. Highly rated bonds guarantee investors will receive their original investment with a small amount of interest, whereas stock prices change daily.
Companies, states, municipalities, and sovereign governments utilize bonds to finance operations and projects. Bondholders are the issuer's debtors or creditors.
Features of Bonds
When you're trying to comprehend how do bonds work, it's important to keep the following features of bonds in mind:
- Issuer: This is the government or government-sponsored business looking to borrow money to support its activities. It promises to pay back its debts in part by issuing bonds.
- Maturity date: The maturity date refers to when you will get the funds back that you borrowed from the issuer. There is no assurance you will receive what you bought for a bond if you sell it to others, although you might be able to do so if you need to or choose to do so before the bond maturity date.
- Face Value: The face value or Par value of a bond is the sum of money it will be worth when it matures. It also serves as the benchmark for the bond issuer for determining interest payments. Most bonds' initial price is usually fixed at par, $1,000 par value per individual bond.
- Coupon rate: This is the yearly percentage of interest that the bond issuer pays bondholders. Bonds can have floating coupon rates, which change over time according to a set formula or fixed, unchanging rate structures.
- Zero-Coupons: Bonds with a zero coupon do not accrue interest over time, as their name implies. Instead, buyers of zero-coupon bonds pay less than the bonds' face value and are paid back the entire face value when the bonds mature.
- Callable Bonds: Bonds that are "callable" allow the issuer to pay down the obligation before the bond reaches maturity. A call clause is negotiated before the bond is issued.
- Puttable Bonds: Puttable bonds, often called put bonds, allow investors to redeem them before the bond reaches maturity. Put bonds may give a single date for early redemption or multiple.
Types of Bond
Bonds balance risk and return, like many other assets. Bonds with reduced risk typically have lower interest rates, while bonds with higher risks usually have increased rates in exchange for the investor having to give up some security. Bonds come in a variety of forms.
Corporate Bonds
Both public and private businesses issue corporate bonds to raise money for ongoing operations, increased production, funding for research, and acquisitions. Federal and state income taxes apply to corporate bonds.
Government Bonds
The federal government issues U.S. government bonds. Because the U.S. Treasury Department gives them, they are usually called "treasuries." The proceeds from the selling of treasuries fund every part of government operations. Federal taxation is due, but state and municipal taxes are not.
Agency Bonds
Government-sponsored enterprises (GSEs), such as Freddie Mac and Fannie Mae, issue agency bonds to pay for federal agriculture, education, and mortgage lending programs. However, some of these bonds are exempt from municipal, state, and federal taxes.
Municipal Bonds
States, cities, and counties issue municipal bonds to fund regional initiatives. Municipal bonds are an attractive investment for high net-worth investors (HNWI) and those looking for tax-free income during retirement because interest collected on them is tax-free at the federal level and frequently at the state level.
Pros and Cons of Buying Bonds
Pros
Bonds are largely risk-free. Bonds can act as a balancing factor when added to a portfolio of investments. If your stock investments make up the bulk of your portfolio, including bonds can broaden your holdings and reduce your overall risk. Additionally, bonds are typically significantly less hazardous than stocks, despite the fact that they do contain some risk (such as the issuer's inability to make interest or principal payments).
A bond is a type of fixed income. Bonds pay the interest at predictable, recurring rates. Bonds can be a reliable asset for retirees or other people who appreciate the concept of receiving monthly income.
Cons
Low rates of interest. Sadly, safety also means lower interest rates. The average annual return on long-term government bonds has traditionally been around 5%, compared to an average yearly return of 10% on the stock market.
Bond risks: Bond investments are not risk-free, despite the fact that there is usually less risk when compared to stock investments. For instance, there is always a risk that you will only be able to sell a bond you own if interest rates rise. Default risk refers to the possibility that the bond issuer won't be able to pay the investor their due interest and principal promptly. Inflation can also lower your buying power over time, depreciating the value of the fixed income you earn from the bond.
Are Bonds a good investment?
Bonds are often advised to comprise at least some component of a diversified portfolio because they are typically less volatile than stocks. Bond values often increase when rates are down because bond prices change inversely with interest rates. Bonds kept until maturity will pay back the principal amount plus any interest accrued along the way. Bonds are, therefore, frequently a viable choice for investors looking for income and who wish to protect their wealth. People should skew their portfolios more heavily toward bonds as they age or move closer to retirement.
