Bonds are debt securities distributed by authorized issuers (business or government entities) that represent a debt owed by that issuer. Similar to a loan, a bond represents a formal contract between the issuer (debtor) and holder (lender), where which the holder gives money to the business to hold. After time has lapsed (i.e. the bond has matured), the issuer is obliged to pay interest (the coupon) and/or repay the principal. This occurs in fixed intervals over a period of time.
Bonds and often associated with stocks because they are both securities; however, there are a couple of major differences between the two. While bonds offer holders a creditor stake because they are lenders for the company, stockholders have an equity stake, meaning they are owners. Another difference is that bonds are based on a defined term (maturity) because since they are simply borrowing external funds to them to finance long-term investments. On the other hand, stocks are usually held indefinitely since the holder has a more permanent relationship as owner.
Corporate Bonds and Government Bonds
Corporate bonds are securities issued by public or private corporations that need to raise money for their working capital or capital expenditures (ex. equipment purchases). Bonds for corporations are broken down into five industry sectors: transportation companies, public utilities, financial services companies, conglomerates, and industrial corporations.
Some types of corporate bonds include:
- Debentures. The majority of corporate bonds fall into this category. These bonds are secured only by the creditworthiness of the corporation issuing the bond.
- Mortgage Bonds. These corporate bonds are secured by physical assets of the corporation, including equipment and buildings.
- Convertible Bonds. These corporate bonds allow bondholders to convert their bonds into shares of stock from the issuing corporation.
- Commercial Papers. These bonds are short term, only representing 30-90 days of corporate debt.
- Callable Bonds. These bonds allow issuers to redeem an issue prior to maturity.
- Guaranteed Bonds. These corporate bonds offer interest payments and/or principal repayment that is guaranteed by a corporation that is not the issuer.
You may also find high-grade investment and high-yield corporate bonds listed as relevant types. For some, corporate bonds can be pretty popular investments strategies. However, because there is a high level of risk associated with lending a company money with no real security attached, some experts believe corporate bonds can prove to be trouble down the line.
Government bonds are similar to corporate bonds with the exception that they are issued by a national government, and in the country’s own currency. The first government bond was issued by the English government in 1693 as a way to raise money to fund a war against France. Currently, government bonds can be used for similar reasons, but mainly to have funds to exchange with the Federal Reserve.
Here are some types of government bonds:
- U.S. Treasury Bonds. These government bonds are considered to be the safest because you can always guarantee a return. However, because they offer low interest rates, you can also guarantee a low rate of return.
- Agency Bonds. These bonds are issued by government-owned financial institutions like Ginnie Mae, Fannie Mae, Freddie Mac, and Sallie Mae.
- Municipal/Corporate Bonds. Not to be confused with corporation corporate bonds, these bonds are issued by varying municipalities to support work in the area.
- Sovereign Bonds. These bonds are issued by national governments in foreign currencies.
- Zero Coupon Bonds. These government bonds have no regular interest payment against it. Instead, in order for holders to make a return, they are bought at discounted rates and redeemed at face value.
Government bonds are popular investment tools because they are virtually risk-free. The government can pretty much always raise money to pay the holder back by the maturity date, so taking this investment route is relatively secure.
Why Bonds Can be Beneficial
There are a number of reasons that investors prefer bonds. Here are a few:
- Diversification. Because bonds are typically less volatile (involve less risk) than stocks, they can be added to your portfolio as a security that is actually secure. This allows you to make riskier investments knowing that at least part of your portfolio offers a lower risk.
- Stability. For investors who are looking for ways to secure money for future investments like college or buying a home, buying a bond is a stable choice because the interest rates don’t fluctuate much.
- Fixed Payments. Bonds offer investors payments in regular, pre-determined intervals, allowing them to know when they’ll be paid.
- Predictable Payments. Because you have also pre-determined how much the interest is, you know how much you will be paid in coupons, as well as when your principal amount will be repaid.
- Higher Interest Rates. While bonds may not offer the return potential of stocks, the interest rates are typically higher than those provided by banks for savings accounts.
- Taxes. Unlike stocks which involved buying and selling (capital gains implications), many bond payments are exempt from federal taxes.
Some Disadvantages of Bonds
Here are a few disadvantages of bonds:
- Lack of High Returns. Unlike stocks, bonds don’t offer the possibility of higher returns because interest rates stay within a basic range.
- Interest Rate Fluctuations. While interest rates typically don’t fluctuate much with bonds, they can. If they do, the price of your bond will decrease so that capital appreciation can make up for the difference.
- Bankruptcy. If a company or municipality goes bankrupt, your bonds will lose value and maybe even become worthless.
- Long-Term Risks. If you purchase a bond when interest rates are relatively low, you could have your money tied up in a low-yielding bond for years with no chance of taking advantage of the current higher rate.
- Call Risk. Occasionally, a company will call their bonds (or force the holders to redeem them) then reissue them at lower rates. This forces investors to take their principal early and reinvest at a rate that will offer lower coupons.
- Economic Inflation. If you purchase a long-term bond at a lower interest rate, you may find that over the years, inflation will affect what your interest payments can actually buy. In other words, you may find that your investment wasn’t as beneficial as you’d hoped.
Can Families Benefit from Bonds?
Families are typically able to benefit from bonds because they are associated with low risks and provide relatively stable saving opportunities. If you are seriously thinking of saving for college or a home, the safest route would be to invest in government bonds, which almost always payout upon maturation.
What Are the Risks of Bonds?
While there aren’t a ton of risks associated with bonds, as mentioned previously, there are a few. For instance, you run the risk of having inflation outrun your interest rate so that when you are repaid your principal, as well as your interest payments, it won’t amount to much money. During this time, your money will have been held up in the investment when it could have been used for investments with higher returns. However, the greatest risk is investing in a company only to learn that it has gone bankrupt. In this case, the risk is not getting any return on your investment at all.
What Else Should You Know about Bonds?
If you’re thinking of investing in bonds, it’s a good idea to look at your investment horizon to determine whether you have years or decades ahead of you. If you’re looking to invest long term then it’s good to secure a higher interest rate. Also, it’s a good idea to spread out your bond investments to cover both short-, medium- and long-term time frames. This way, you can get cash when you need it (short-term), but also take advantage of higher rates with longer-term bonds.
Buying bonds is a great investment tool for those who are interested in low-cost options with low risks. If you’re interested in taking this route, it’s time to begin researching your options to get started the right way.