So you can better decide how to choose the best investments for you, here’s what you need to know about bonds.
A bond is a debt obligation. Entities such as a government, corporation, municipality or another issuer use bonds to raise capital and finance a number of activities that might include infrastructure development, mergers and acquisitions. Investors then purchase those bonds and loan money to the entity for a period of time with the issuer promising to pay the investor a specified rate of interest over the life of the bond and to repay the bond when it comes due.
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Types of Bonds
The three most common entities seeking to raise capital in the U.S. through the issuance of bonds are federal and state governments, local municipalities and corporations. In the U.S., government bonds are issued by the federal government and state governments. Debt issuance by local governments is characterized as a municipal bond.
U.S. government bonds are debt products backed by the faith and credit of the United States government. These bonds are typically known as “sovereign bonds.” Most government bonds provide interest payments at different periods — typically six months — and provide the initial lump-sum investment back at maturity, or when the original principal will be returned to the investor.
These are the various types of government debt classified by maturity:
- Treasury “bills” are bonds that mature within one year or less.
- Treasury notes have maturation levels of two, three, five, seven and 10 years.
- Treasury bonds — also known as T-bonds — mature in 30 years.
Given that the U.S. government stands behind U.S. Treasuries with its taxing power, these bonds are considered virtually free of default risk. These bonds are also tax-free on the state and local level.
The federal government also issues zero-coupon bonds, which are bonds that do not pay interest during the life of the bonds. These government savings bonds trade at a discount to their long-term value. With these bonds, when they mature, the investor will then receive one lump sum equal to their initial investment plus the imputed interest. A bond like this might be used in a situation where you are planning for a long-term goal, where you want to invest a small amount of money that will grow over many years.
Advantages and Disadvantages of Bonds
Investors have many options when choosing an asset class. Bonds have different advantages and disadvantages to consider before making an investment. These factors traditionally involve opportunity costs, regulations and the risks associated with the asset. The following bullets provide a few key advantages and disadvantages of buying and owning bonds.
Advantages of Bonds
Here are some of the benefits of bonds:
- Traditionally, bonds have lower volatility than equities on the stock market.
- Bonds are liquid, meaning it’s easy to buy and sell them without significant swings in prices.
- Bonds pay interest regularly.
- Some bonds provide a tax-free income.
Disadvantages of Bonds
Bonds do have a variety of risks and drawbacks as well:
- Fixed-rate bonds are subject to interest rate risk, which will drive down the value of the bond should rates increase.
- When interest rates increase, the market price of a bond decreases.
- Bonds are also subject to a number of different risks including credit risk, liquidity risk, duration risk, inflation risk and call risk among others.
Government bonds are subject to interest rate risk, although they can be good investments for individuals seeking income generation and a way to preserve wealth.