What Are Bonds and How Do They Work?
Today we’re going to take a step back and answer an important question: What are bonds?
What Are Bonds?
Our economy runs on debt. And bonds are an important piece of the debt structure. They allow governments to function and companies to grow. Without bonds, large organizations vital to the economy would collapse.
Bonds are loans made to large organizations. And when you buy a bond you are entering into a contract. The contract is between the borrower (government entity or company) and the lender (investors like you). Bonds are usually used by government entities and companies to finance operations. Before we dive into the different types of bonds, let’s review some important characteristics of bonds.
Characteristics of Bonds
These terms are vital to understanding how bonds work.
- Face value is the amount of money the bond will be worth at maturity. In other words, it’s the contractual amount being repaid to the lender.
- The maturity date is the date on which the bond contract ends. On that date the borrower or issuer must pay the lender the face value of the bond.
- The coupon rate is the interest paid by the bond. Most bonds pay out their coupons on a semiannual basis. As an example, a 2% coupon rate on a $1,000 bond means that the bondholder will receive $20 (2% of $1,000).
- The yield to maturity is the estimated rate of return that an investor can expect from a bond. The value assumes that you hold the bond until maturity. Yield to maturity is also referred to as the redemption yield.
What are the Different Types?
There are several different types of bonds. The type of bond depends on who is issuing them, the length of time until maturity, the interest rate and the risk. Today we’ll explain the three most common types of bonds.
Government or Treasury Bonds
Government bonds are issued by the U.S. Treasury and are usually just called Treasurys. They are the highest quality bonds available because there is little risk associated with them. They are issued by the U.S. Treasury through the Bureau of Public Debt. So unless the government collapses, you can count on getting your money back. Another great advantage to Treasurys is that the interest earned is exempt from state taxes.
Types of Treasurys
- Treasury bills are short term bonds. They mature in less than one year. They are sold at a discount from their face value and therefore don’t pay interest before maturity.
- Treasury notes earn a fixed interest rate every six months. They have maturities ranging from one to ten years. The 10-year Treasury note is the most popular debt instrument in the world.
- Treasury bonds have maturities ranging from 10 to 30 years. They also have a coupon payment every six months.
- Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds. That means the principal value of the bond is adjusted according to the Consumer Price Index. They typically have maturities ranging from five to 20 years.
Municipal bonds are issued by state and local governments to fund important operations. These include the construction of highways, schools, sewer systems and countless other public projects.
In many cases, municipal bonds are exempt from federal income taxes. And in some cases they are even exempt from state and local taxes for people who live in the municipality where the bond was issued. Municipal bonds can offer competitive rates, but they are riskier than Treasurys because local governments can go bankrupt.
Corporations frequently issue bonds to fund expansions or large investments. Corporate bonds are riskier than government bonds because corporations are more likely to default on their debt. However, corporate bonds generally have higher yields.
The value and the risk of the bond largely depends on the financial health and credit reputation of the company issuing the bond. Junk bonds, those issued by companies with poor credit ratings, are the highest paying corporate bonds, but they are also the riskiest.
How They Work
Bonds are just loans. Ordinary citizens take out loans all the time. Without them people wouldn’t be able to afford a home, a car or an education. Businesses need to borrow money to finance new operations and grow. Often, they need more money than a bank is comfortable loaning them. So, they issue bonds.
When you buy a bond, you are simply lending money to an organization. Whether it’s a private company or a government entity. In return, the organization promises to make interest payments for the length of the bond. The interest rate, or coupon rate, is normally higher with long-term bonds. If the current interest rate is higher on short-term bonds, the yield curve is inverted. And it doesn’t happen often.
As we’ve mentioned before, the interest payments are usually made on a semiannual basis. When the bond reaches maturity, the issuer repays the principal, or the original amount of the loan.
Compared to investing in stocks, bonds are very straightforward. The risk depends on how reputable the bond issuer is. Fortunately, Treasurys are very safe. Corporate bonds are also relatively safe depending on the company.
Bond investing should be a part of any smart investor’s strategy. It provides diversification while hedging against some volatility in the stock market. With bonds, you can determine the level of risk you want to expose yourself to. Which is harder to do in the stock market. Plus, you can “Make a Killing… With Bonds.”
We hope this article helped you understand bonds. For more educational pieces like this, check out our financial literacy section. It is packed with valuable information that every investor should be armed with.