Bonds are debt securities that various entities issue to raise money. The entities promise to pay the bond buyers back, with interest, after a certain period. Although bonds are considered relatively safe investments, they differ widely based on their purpose, who is issuing them, and their terms. Therefore, it’s important to know how bonds work and understand the risks of bonds before you invest.
Who Can Issue Bonds?
Bonds can be issued by government entities, including the U.S. Department of the Treasury and state and local governments. Companies can also issue bonds. Corporate bonds are regulated by the U.S. Securities and Exchange Commission, which mandates that issuers comply with requirements like offering a prospectus that discloses the terms of the bond, risks of investing, the company’s financial condition, and how the proceeds of the bond will be used.
How Do Bonds Work?
Purchasing a bond is like loaning money to the bond issuer. When you buy a bond, the bond issuer repays you according to the terms of the bond. Interest typically is paid twice each year, and the face value of the bond is repaid at maturity. After a bond is sold by the issuer, it can be resold on the secondary bond market.
Characteristics you should pay attention to when comparing bonds include:
- Interest rate: The interest rate on a bond determines how much interest the bondholders get paid. An interest rate can be fixed, which means it stays the same, or adjustable, meaning it adjusts as interest rates adjust.
- Term: The term of the bonds tells you how long it will be until you get your money back. A bond selling for $100 and paying you $150 at maturity might sound great if it matures in five years, but might not sound so great if the maturity is 50 years.
- Credit risk: A bond purchase is a vote of confidence in the issuing entity’s ability to make the payments it says it’s going to make. If the company or government entity defaults or goes bankrupt, you can lose your entire investment.
Types of Bonds
Check out details on the different types of bonds available so you can decide if one might be right for you.
- U.S. savings bonds: U.S. savings bonds are issued by the federal government, and because they’re essentially loans, they’re part of the national debt. These bonds are very safe because of the low chance the government will default on the payments, but they offer a limited yield. Series I savings bonds have a variable interest rate tied to inflation. Series EE bonds earn a fixed interest rate.
- Municipal bonds: Municipal bonds are issued by state and local government entities to raise money for projects. The interest you earn on these bonds is exempt from federal income taxes. You can purchase two types of municipal bonds. General obligation bonds must be repaid regardless of whether a project is successful. Repayment for revenue bonds, on the other hand, relies on income generated from a specific source of revenue.
- Corporate bonds: Companies issue corporate bonds to raise money for their operations. Corporate bonds can range from high-quality bonds issued by companies that are very stable to speculative bonds issued by companies that pose a higher risk of defaulting on repayment.
- Private placement bonds: This high-risk type of corporate bond has fewer SEC disclosure requirements than regular corporate bonds but more restrictions on the size of the debt and who can buy the bonds. SEC regulations state that private placement bond buyers must have high income or high net worth.
- Secured versus unsecured bonds: Secured bonds are backed by collateral — specific assets — to protect investors. For example, a company might pledge its factory and machines as collateral for a bond issue. Unsecured bonds have no collateral.
- Convertible bonds: These are a type of bond issue that gives the holder the right to exchange the bond for stock in the company of the bond issuer at a predetermined value. Convertible bonds are like stocks in terms of risk profile and performance.
Find Out: How to Cash Savings Bonds
Stocks vs. Bonds
A diverse portfolio might include both stocks and bonds to achieve a good balance between risk and returns. When deciding whether to buy stocks or bonds, investors often pick bonds because bonds provide dependable income with interest payments. In addition, federal, state and local government bonds can provide income tax advantages. That doesn’t mean bonds are without risk. Inflation could rise, reducing the effective return generated by the interest rate, and in a worst-case scenario, the entity issuing the bond could go bankrupt. But in general, bonds can serve as a simple, low-risk addition to your portfolio.
Keep Reading: How to Choose the Best Bonds for Your Financial Plan