In simple terms, purchasing a bond is purchasing debt. You have essentially lent money to the bond issuer and they have made a commitment to pay that money back with interest.
You can make money off bonds by holding them until maturity, or selling them when their value is higher than what you paid for them.
How bonds work
Bonds are issued to raise capital. A company could use them to fund expansions or a government could issue bonds to pay for an infrastructure project. In return for the purchase, the bondholder receives a fixed income return.
This return, which is usually paid twice a year, is determined by a ‘coupon rate’ which defines the interest that the issuer will repay on top of the original amount they were lent. The bond issuer will also specify a maturity date for the bond, which determines its lifespan.
Investors can buy bonds when they are issued through a broker. Alternatively, government bonds, such as US Treasury bonds, are purchased directly from government-backed websites. Bonds can also be bought and sold after having been issued. This again takes place through a broker, or through a marketplace provided by the issuer, such as the US Treasury’s TreasuryDirect service.
You can think of it in simple terms like lending money to a friend. You might agree to give them $100 on the condition that they repay the amount, plus a little bit extra, over the course of a year. In this theoretical agreement, your friend could agree to pay two instalments of $60, repaying a total amount of $120 and netting you a profit of $20.
Types of bonds
Bonds can be distinguished by the nature of the issuer. For example, corporate bonds are issued by a company, while government bonds or sovereign bonds, such as US Treasury bonds, are issued by a nation’s government or central bank. Finally, municipal bonds can be issued by public entities smaller than a nation, such as a county, city or state.
It is also worth noting that further categorisation exists within these variants. For example, bonds issued by companies with high credit ratings are referred to as ‘investment-grade’ and are seen as carrying a lower risk. High-credit bonds are generally at the other end of the spectrum, offering higher returns but carrying more risk.
Bonds can also be secured or unsecured. The former are backed by collateral, assets which will pass into the ownership of the bondholder if the issuer is unable to make the agreed repayments. The latter do not include this safety net and are consequently a riskier investment.
Additionally, different bonds have different maturities. This refers to the amount of time for which the issuer is obligated to pay the bondholder. Short term bonds tend to have a lifetime of between one and three years, medium term have a lifetime of up to ten years and long term bonds stretch beyond that.
Another increasingly relevant category is green bonds. These are issued by companies, governments, or municipalities in order to fund projects that are good for the environment.
Green bonds are relatively new, but have been issued by major players such as Apple and Toyota.
Advantages of bonds
The major advantage of bonds is that they can decrease the risk of a portfolio. Times of stock market volatility generally see investors rush to ‘safe haven’ investments such as government bonds, to protect their money.
The reliable income of bonds is also a plus, as it creates a predictable stream of cash. If you know that you will require a certain level of regular income, bonds can be a great help.
Furthermore, income from some types of bonds can be exempt from taxation. These tend to be municipal bonds, which are exempt from federal tax and some local taxes.
Finally, there is the point that investing in bonds can allow you to invest in progress. Municipal or government bonds can fund improvements that really benefit society, such as the construction of schools or hospitals. Making money is nice, but making a difference with your money is nicer.
Disadvantages of bonds
On the downside, bonds can yield less spectacular profits than some other investments. Lucky or skilled investors can net themselves eye-watering returns with equities, but bonds are more of a stable and reliable investment.
The value of bonds is also highly dependent on interest rates. Bonds are generally more valuable when interest rates are low, as their fixed interest becomes attractive. However, rising interest rates cut the value of bonds, as the fixed interest becomes unattractive.
Additionally, bonds carry default risk. This is the risk that the issuer will default on the debt that the bond represents. The risk of this happening tends to be lowest with government bonds and highest with high-yield corporate bonds.
Finally, there is the chance that the debt may be paid off ahead of schedule. This happens when certain requirements listed in the initial contract for the bond are met. These requirements, which might be the bond reaching a certain price, are called a call provision.