A bond is a structured loan used by large organizations like governments or corporations to borrow money. For the people buying bonds, they are a way to invest money that provides safe, steady returns with a very low probability of losing their investment, making them an important, low-risk alternative to stocks.
A bond is, simply put, a loan with a defined structure for the borrower to pay back what they owe with interest on a preset schedule. Bonds are, generally speaking, among the safest investments you can make. It’s relatively rare for debtors to default on the money they owe, so with a few notable exceptions, bonds offer safe, predictable returns.
Every bond will typically have three important factors: yield, maturity date and rating.
The rating is a grade issued by one of the three main credit-rating agencies (Moody’s, Fitch and Standard & Poor’s 500 Index) based on the likelihood that the borrower will default.
A bond that has been repaid in full has “matured,” so maturity date is the length of time until the full value of the bond has been repaid.
A bond’s yield is its interest rate. Generally speaking, yields are higher the more risk is involved. Thus, longer time to maturity and/or lower ratings reflect greater unpredictability and usually mean higher yields.
There are a variety of methods for structuring the interest payments and repayment of principal, but the most common one features quarterly (every three months) “coupon payments” for the interest with a full repayment on the date the bond matures.
So, if you buy a $1,000 10-year T-bill from the U.S. Government with a 3 percent yield, you are essentially agreeing to loan the federal government $1,000 for 10 years at an APR of 3 percent. You’ll receive $30 a year in interest spread out across four payments of $7.50, and then when the 10 years are up, the bond will “mature” and you’ll get your initial $1,000 back.
Most people don’t make direct bond purchases. Bond trading tends to be dominated by the investment banks and lacks many of the user-friendly options you can find with stock markets. In order to participate directly, you will most likely need to hire a bond broker, most of whom will require a minimum deposit of at least $5,000.
The much simpler option is to rely on mutual funds and Exchange-Traded Funds (ETFs) known as “bond funds.” These are portfolios of bonds that are selected under a specific criteria or handpicked by an expert fund manager and allow investors to indirectly invest in the bond market. You should be able to invest in bond funds through your individual retirement account (IRA), 401k or other trading platform, but be careful to pay close attention to the fees charged by each fund.
Bond markets play an essential role in the global economy, providing an avenue for everything from a mid-sized American city to a thriving Japanese corporation to secure the money they need at the lowest possible cost. That said, the markets are also quite complex, with many different types of bonds serving a wide variety of different organizations.
U.S. Treasury Bonds
The United States borrows hundreds of billions of dollars a year, and the debt that they issue has become an important part of global money markets. There are three types of federal government debt based on the different time to maturity for each: Treasury bonds (T-bonds), Treasury notes (T-notes) and Treasury bills (T-bills). T-bonds mature in 20 to 30 years, T-notes in one to 10 years, and T-bills in anywhere from a month to a year.
These bonds are among the safest investments in the world, and they play a key role in helping banks and other financial institutions keep their balance sheets stable.
The U.S. Treasury also offers savings bonds that are geared towards individual investors and are usually purchased directly from the U.S. Treasury.
Savings bonds can be purchased for amounts as small as $25 and pay interest until they’re cashed in, which can be anywhere from one to 30 years from the date of purchase. They don’t offer coupon payments and instead allow the interest to accumulate until it’s paid out in full when the bond is cashed in.
Series EE bonds offer a fixed rate of insurance while Series I bonds include a variable rate that adjusts for inflation twice a year.
Municipal bonds are issued by city or state governments for everything from covering budget shortfalls to raising capital for a major public project.
Municipal bonds have the added bonus of being free from federal taxes, so when comparing “munis” to other bonds, be sure to consider the tax advantages when gauging your returns.
Corporations will need to borrow money for a wide variety of reasons, and they will frequently do so by issuing bonds.
Corporate bonds can include what are known as “convertible bonds,” which give investors the option to convert their bonds into stock at a predefined ratio.
The phrase “junk bonds” refers to high-yield bonds issued by corporations or governments on relatively unsound financial footing. Since there’s a real chance that these companies might default on some or all of their debt, they have to offer much higher interest rates to attract investors.
While bonds are typically a low-risk alternative to stocks, the world of junk bonds can often involve just as much if not more risk than trading stocks, so let the investor beware!
Bond markets are global, and most governments and corporations in other countries are also issuing debt in the form of bonds. As such, investors can buy up debt issued by foreign governments just like you would the United States.
While some of these bonds are likely to be just as rock-solid as U.S. Treasuries, other countries are much less secure. Investors in Greek debt, for instance, had to take a costly “haircut” on that country’s bonds in 2011 that wiped out half of their initial investment.
There are a number of other financial products referred to as “securities” that offer steady income streams along with full repayment of principal. These will usually be created by investment banks by buying up a certain asset type and structuring it into something that can be sold to investors.
Probably the most famous (or infamous) example would be mortgage-backed securities, which bundled the home loans of thousands of individual Americans into a single bond-like entity. However, there are plenty of other types of securitized debt products that take income streams from everything from rooftop solar panels to auto loans and package them together so they can be bought or sold on financial markets.
As demonstrated in the crash of the housing market, though, the risks associated with securitized debt products can vary widely, so it’s important not to assume they’re going to be as safe as most bond investments.