As you are handling your investments or reading the news, you might come across the word bond. What is a bond? What does it do? When is it appropriate to buy? In this article, I will try to explain the basics of financial bonds in the simplest terms.
How does a bond work?
A bond is a loan by the buyer to the seller, which is usually a government or corporation. It is fixed-income, which means it pays a fixed amount of interest every year, and at the maturation date, the date at which the loan is due, it may be turned in for the original amount of money loaned. Bonds’ main function for the buyer is to maintain and grow wealth.
For example, if you buy a U.S. Treasury bond for $5000 with an annual interest rate, sometimes called coupon rate, of 3% for 10 years, every year you will receive 3% of $5000 or $150 and in 10 years, the $5000 will be returned to you; In total, the investment would net you $1500 in 10 years or 30% of the principal investment.
How are bonds used?
In terms of the seller, city, state, or corporate bonds are used to raise capital/money; if a city wants to build a new park without having adequate money, they might issue bonds to pay for it, essentially taking a loan from the people. The U.S. Federal Government, and many other governments, use bonds differently; they buy and sell bonds to control the money supply, or the amount of money in the economy. This is not an important function of bonds to know as an investor, as it only pertains to the big picture, but it does explain the sometimes changing interest rate.
The changing interest rate can lead to you owning bonds which have a lower interest rate than the market interest rate. If you try to resell bonds to other investors when the current interest rate is higher than the interest rate you bought the bond at, you will need to offer your bond at a discount to attract buyers.
What are some drawbacks to bonds?
Bonds are not full proof. If the bond seller cannot pay its bond payments, it can refuse to pay them, making them worthless; Argentina has defaulted its bonds several times, and as a result they are considered toxic to investors. In general, U.S. bonds are one of the safest investments because they are backed by the U.S. Government. The most risky domestic bonds are corporate bonds, as corporations can go bankrupt, so to allure buyers corporations often offer higher interest rates. Credit agencies will rank the riskiness of bonds, using the letter system. Bonds rated AAA are extremely safe, while bonds given lower than B should rarely be bought.
In short, bonds are usually low-risk, low-reward investments. And as a result, they are a great way to save for retirement as you grow older; Bonds do not have as high a growth rate as stocks or other investments, but they do safely preserve and slightly grow wealth for retirement.