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Investing 101

Investing In Bonds

August 29, 2019


The investment world is dynamic, from stocks to ETFs, index funds to mutual funds, and CDs to bonds, there are plenty of options. And this diversity often confuses the investor. It becomes difficult to decide which investment option is better and has a higher ROI than others. While there is some level of risk attached to most of the investment methods, bonds are a rather safe option on the risk ladder.

What are Bonds?

Essentially, bonds are loans from an investor to large organizations, such as corporations, cities, or the government. The investor lends the money to any of these organizations and receives payment at a fixed rate of return at scheduled intervals. Hence, bonds are a means of “fixed income security” and a safe way to invest in your future.

Investing in bonds not only guarantees a payback with interest, but also helps diversification in an investor’s portfolio. It is always good to have some investments in bonds as they help to balance out the risks. You never know when the stock markets may crash. Hence, bonds can help survive through such a crisis.

How Bonds Work

The borrowing body agrees to pay the bond back at a pre-determined date. Until the bond matures, the bondholder gets interest-payments at regular intervals. The bond owners are the creditors or the debt holders who have to pay the face value, i.e., the principal at the maturity date. Most bondholders prefer to resell their bonds in a secondary market. So, either the bonds get traded publicly on exchanges or it may be a private affair between a broker and creditor.

Characteristics of Bonds

Before discussing the types of bonds, and how they work, let’s go through some basic characteristics of bonds for a better understanding.

  • Coupon: It is the amount of interest the investors receive against the bonds on regular intervals, either once a year or semiannually.
  • Maturity: A bond matures when the principal amount of the bond is paid to the investors.
  • Secured and Unsecured Bond: The interest payment and return of principal of the unsecured bond, i.e., debentures, are guaranteed based on issuing companies creditworthiness. Whereas, in a secured bond, the investor gets some assets as a security in case the company fails to repay.
  • Liquidation: In case of bankruptcy, a company sells off its assets to pay out the investors. The liquidation process follows a particular order from the senior debt being the first to be paid.
  • Callability:  Issuers may choose to pay some bonds with a call provision before the maturity date at a slightly higher premium.

Types of Bonds

There are many types of bonds available in the market concerning the issuer, maturity length, interest rate, and risk involved.

· US Treasury Bonds

The Treasury Department of the US government issues bills, notes, and, bonds, also called Treasuries. Since the government backs these bonds, they are the safest, marketable bonds with little risk of default. Further, T-bonds make payments semiannually, while the income is taxed only at the federal level.

The treasury department auctions the T-bonds for funding the federal government’s operations. You may directly buy T-bonds from the Treasury Department, or a broker in about $100 increments. The T-bonds mature for 10 to 30 years.

· Municipal Bonds

Various cities and localities issue tax-free Municipal Bonds. These bonds have low-interest rates compared to other types of bonds. Also, municipal bonds are risky to invest as city governments do default occasionally.

 Like the T-bonds, municipal bonds are also marketable; hence, the bond’s price changes.  However, the interest rate and ROI don’t ever change if the investor holds on to the bond. You can buy municipal bonds through a financial advisor, a bank, directly from the municipal, or a bond fund.

· Corporate Bonds

 Corporate bonds are the bonds issued by different companies. They involve more risk than T-bonds, and therefore, offer higher return rates. There are three types of corporate bonds that representative banks sell.  

  • Junk bonds: These are issued by companies vulnerable to get defaulter and offer high-interest rates to compensate.
  • Preferred Stocks are primarily stocks acting like A-bonds paying a fixed dividend regularly.
  • CDs are similar to bonds as the investor lends money to the bank for a specific period and gets a fixed rate of return.

Bonds: Advantages and Disadvantages

Like the other ways of investment, bonds also have some benefits to offer along with some risk factors. Let’s discuss each of them separately.

Advantages

  • Investing in binds pay you back in two ways.
  • The interest payment that you receive every six months against the bind you hold until it matures. Hence, you get income security.
  • Most of the bonds are marketable; hence, you can resell the bonds at a higher price and yield some profit.
  • You don’t have to buy bonds directly to enjoy the benefits as you may purchase a specific number of shares in a mutual bond fund.
  • You get the services of a professional fund manager who searches the best bonds for you to invest.
  • A bond fund lowers the risk through diversification. Hence, any of the entity in the mutual fund gets default on its bonds, only a fraction of investment is lost.

The Risks

  • A big risk involved in investing in bonds is the default risk; companies may default. Hence, you may not get the required interest and principal payment.
  • Bonds have a lower payout return on investment than stocks. And, you may not be able to save much for retirement by only investing in bonds.
  • Bonds may not alone provide sufficient assistance to outpace inflation. It is better to have diversification in your portfolio.
  • Prepayment through a call provision is yet another risk for investors. The companies avail a call provision when there is a drop in the interest rates.

FAQs

  • Which bond is the safest for investment?

The treasury bonds are the safest as the US government backs them. These risk-free bonds are only taxed at the federal level.

  • How long you can I hold onto a bond?

Bonds have varying maturity periods ranging from one year to 30 years. You may either hold the bond until it matures or resell the bond in the secondary market.

  • From where can I buy the bonds?

You may buy a bond from an online broker, or an investment bank in an initial bond offering. Also, you may purchase a bond through an exchange-traded-fund or directly from the US treasury department.

Final Word

The bond market may seem slightly complex to you, and you may dread to invest your money in bonds. However, the bond market works on similar lines to the stock market.  Also, it involves risk and returns on tradeoffs of similar magnitude. Don’t get overwhelmed; take the first step, and dive into the pool. You will eventually learn to swim across and unmask the dynamics of the bond market.

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