If you’re looking for an investment that is fairly safe, then bonds may be worthy of your consideration. But they aren’t right for everyone. There’s more to them than meets the eye. In this guide, you’ll learn about bonds and investing in them. However, the purpose of the guide is NOT to teach you everything under the sun about bonds. Instead, the goal is to provide the most pertinent information and tips to help you understand what these securities are, and how and when to best acquire them for your portfolio.
I’ll start by giving a quick definition of a bond, and from there I’ll cover the types of bonds, why they may or may not be a good investment, impact of interest rates, risks, and how to go about investing in them.
To get the most from this training guide, I suggest that you not jump around. Start with this section and then read through the rest of them in the order they are presented. When you’re done, I promise that you’ll be more knowledgeable about this subject and more confident in your investing skills. Let’s get started.
What is a bond?
When a corporation or government wants to raise money for a project, such as building a factory or new school, it has a few options. In the case of a corporation, one alternative method is to issue more stock shares.
So, for example, a company could allow 1,000,000 new shares of it’s stock to be sold on the New York stock exchange to investors like you and me for $20 each. They can then take that new $20,000,000 and do whatever they like with it.
But many times, a corporation may not want to flood the stock market with more stock shares because it could send a bad message to stock market watchers. Existing investors might also feel that such flooding could decrease the value of their shares.
Think of it like splitting a pie between 16 people, whereas before there were only 6. It’s not quite that simple, but it helps to make the point why corporations often avoid going this route.
Of course, city, state, and federal governments don’t have stock shares to sell. So one of their alternative methods for raising money is to increase taxes. It could be in the form of sales taxes, income taxes, or property taxes, for example.
But you know as well as me that just about any time the idea of increasing taxes is brought up, there is fierce debate and resistance. So politicians and government officials usually only mention this option when they feel the timing and political climate are ideal.
The bottom line is that corporations and governments have to consider many factors when deciding how to raise money. That’s where bonds can come into play.
When a giant corporation such as Apple, Inc., or your hometown issues bonds, they are, in essence, borrowing money directly from you. You will hold an I.O.U. loan document.
When you buy into a bond, it will have an assigned fixed interest (coupon) rate and time period for when the bond will mature. For example, it could mature in 2 years or 10 years.
Depending on the bond, you could be paid interest on a periodic basis, such as semi-annually, or you could receive it along with your original investment amount all at once when the bond matures. One of the advantages of bonds is that you won’t experience the crazy price swings that are associated with many stocks.
Of course, corporations and governments will generally issue bonds to raise many millions or even billions of dollars. There’s a whole marketplace and infrastructure that evaluates, regulates, and controls the buying and selling of bonds.
It consists of Wall Street investment bankers, bond exchanges, underwriters, brokers, and sales agents. It’s through this process that allows you to bite off a small bond for $1,000 or whatever amount, and sell it any time you want as well.
So when it comes to raising money, there is less heat attached to bonds. They aren’t nearly as sexy as stocks, and won’t attract anywhere close to the public scrutiny that raising taxes will.
3 Important Bond-Related Questions
I’ll get into the nitty gritty of the pluses and minuses of bonds elsewhere. But there are three bond-related questions that I want to cover because they seem be at the top of people’s minds. Here they are:
1. What does bond maturity mean?
The bond maturity date represents the end of the loan arrangement between you and the bond issuer. All terms must be settled at that time, including the return of your original investment amount (or principal). So, in theory, a bond could mature in 6 months, 30 years, or any time frame.
The maturity date is very important. That’s because the overall market interest rates in the economy will rise and fall on an ongoing basis. So the longer the maturity of your bond, the more frequently it’s price will change in the marketplace should you decide to sell it at some point prior to the end of the maturity date.
As I alluded to earlier, there is a bond market, just like there is stock market. The bond market is no where near as volatile as stocks, but there is a constant buying and selling of new and existing bonds.
In any event, a longer maturity is not necessarily a bad thing. It just means that you should pay closer attention to what’s happening with market interest rates. For example, you don’t want to get stuck with a bond that begins to significantly underperform other investments that you could have switched your money into. Fewer people will want your really long term bond if it’s carrying a fixed rate that is substantially lower than other bond rates.
Now, if you’re still a little fuzzy about interest rates, don’t worry. I’ll cover them in more detail in a separate section.
Anyway, there are three classifications of bond maturities. Here they are:
Short term – These bonds will mature within 3 years.
Intermediate term – These bonds will mature in 3 to 10 years.
Long term – These bonds will mature sometime after 10 years. Most long term bonds these days tend to have a maximum length of 30 years.
You can expect longer term bonds to offer higher interest rates than shorter term bonds because there’s more risk involved with holding on to bonds for many years.
2. How secure are bonds?
Bond are pretty safe and secure. If you purchase a corporate bond and the company runs into big financial trouble, then you will get in line ahead of all stockholders when it comes to getting some or all of your money back.
You’re also in good hands with government bonds. I know that the city of Detroit filed for bankruptcy, but such situations are extremely rare.
But that raises a key point. There are several levels of bond quality and safety. They aren’t all equal. I’ll discuss what you should look for in the bond risk and quality section of this guide.
3. Are bonds a better investment than stocks?
There is no easy yes or no answer to this question. That’s because one of the key variables in play when it comes to choosing one or the other is your investment risk tolerance. We are all different in this regard and our risk tolerance level should and will change over the course of our lives.
You’ll often hear that bonds are intended for conservative or low risk investors because, as I mentioned, they are fairly safe. At the same time, history has shown that the profit returns on bonds don’t hold a candle to the long term returns on stocks. Thus, stocks are much riskier than bonds.
I guess you could say that stocks have a higher potential return on investment ceiling and a lower investment loss floor.
This is one reason why, for example, financial advisers generally recommend that you have little or no bond holdings in your investment portfolio when you’re in your twenties, but you should have a big chunk when you reach your sixties.
When you’re young, time is on your side, and you can bounce back from multiple downturns in the stock market. But having said that, a young person could strategically invest in bonds under certain circumstances. Read [[[Why invest in bonds]]]
So now you know the answer to the opening question, “What Is a Bond and How Does It Work?” At it’s core, it’s nothing more than a loan that you make. And yes, when you listen to the talking heads bantering on television, it sounds like a complicated investment. But for the average investor, most of what they are saying is useless background noise. Just follow our tips in this guide and you’ll know when it’s time to invest in bonds and which ones are the best.
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