Many men and women know the value of investing, but because overwhelmed by the sheer number of ways to invest. You may be asking, “Well, what is a bond, then?” Bonds are significantly different than most other investments, but they can also be quite valuable to you, depending on what your goals are. If you are looking for a relatively safe way to invest your money, and you do not expect to need those funds immediately, bonds could be the right route for you to take.
Bonds are a very common type of investment. Forms of them have helped to fund cities and countries. They have been used to build some of the largest companies in history, too. Let’s talk about how they work and why you should be using them.
How Do Bonds Work?
Bonds are a very simple and straightforward type of investment tool. In short, you are lending an entity or individual money. They promise to pay it back to you in full with interest, but at a later time. Most often, the later time is years. That is a simple definition, but bonds can also be a bit more complex.
For example, many companies issue bonds. That means they put out a request to investors that they want to raise money by selling a bond. With these bonds, you are not taking ownership of the company in any way – that is more like what happens with a stock. Instead, with bonds, you are lending money to an entity that they will use in any way they would like to. Companies that sell bonds are selling on a larger scale, often raising millions of dollars in the process.
Many times, these bonds will come with a few specific promises. For example, the company promises to repay you exactly what you lent to them at a specific time. You agree to this, and, they pay you back with interest. Bonds are not get-rich-quick methods by any extent, but they can be relatively safe investments if you know and trust the company behind them.
What Do Companies Use Bonds For?
There is no hard rule about what bonds can be used for by a company. Most of the time, they are used for things like expanding the business or adding a new location. They generally are issued in times when there is growth – which tends to mean good things for investors. Yet, there are no rules governing what the company can do. In other words, they can take the funds and use it to pay for whatever they need. This means investors really do need to know the company and its current financial health before making any decisions to lend to them.
How Are Bonds Different from Stocks?
The two are some of the most common forms of investments that people make today. And, yet, they are also very different. Bonds and stocks are both issued by companies who are looking to raise money. Like with bonds, companies raising funds from stocks can use the funds for a wide range of needs. If you are thinking about investing in either of these, though, you need to take a closer look at them.
Before going further, remember that the investment vehicles – in this case, stocks or bonds – are just the beginning of your search. You also need to research the companies you are investing in directly and make sure they fit your financial plan and investment goals.
People buy stocks and bonds for a variety of reasons, including the fact that they are rather straightforward ways to support a company and to grow the value of your portfolio. Yet, there is more to them than this.
Buying and Selling Stocks and Bonds
Both stocks and bonds are bought and sold on the open market. That means you can purchase bonds or stocks from a company that is issuing the call for funds. However, let’s say you decide you do not want to maintain the ownership in that bond or stock any longer. You need to access some of your investment, for example. You can sell the bond or the stock to someone else who is willing to buy it on the market. This creates a bit more freedom than bonds used to have.
What makes these two investments so different is their actual benefit or what you get from them. With a bond, you are purchasing a promise to pay – a type of IOU from the company. However, with stocks, you are purchasing actual ownership in the company. Of course, stocks are very small portions of ownership, but they still give you some actual ownership and are a true asset in that way.
Another key factor about the way they differ is how they earn money for you. As noted, in a bond, a company will sell the bond and promise to repay that amount plus interest. This is pretty direct – you know what you are paying and what you are likely earning. That is not the same as it is with a stock.
With a stock, the value of the stock is going to change frequently based on the market itself. If a company grows in value – perhaps reports good financial standings and revenue growth – that causes the value of the stock to rise. By the same token, then, if the company starts to struggle, the value of the stock may fall. It really comes down to the law of supply and demand. When a company is doing well, the demand for stock increases, pushing values up.
How much you earn with a bond depends on the current interest rates. When a bond is issued, the company will provide a specific interest rate. That is the amount you will earn on the bond over time. That interest rate can change from one call for bond sales to the next – though they do not change within the term that you own them.
For example, if a company issues a need to sell bonds, it will promise to pay, for example, 5 percent in interest because that is the going interest rate in the market (this is just for clarification and does not represent any true interest available). A few years later, the company decides to raise more money by selling bonds. This time, interest rates are 6 percent. The new bonds issued will have the 6 percent rate while the old ones you may own maintain their 5 percent.
Company Success Can Matter
Another way to compare stocks and bonds is based on how the company does. As noted, if a company performs well, a company’s stock will rise. If the company does badly, that may lead to a drop in the value of the stock.
This danger isn’t the same with bonds. However, bonds can have some risk. If a company is doing very badly and plans to declare bankruptcy, that can impact your ability to receive the payment promised by the company.
Breaking Down Bonds – What Features They Offer
When you are ready to consider buying bonds, it’s important for you to understand the details of each one. Here’s a breakdown to use.
The Face Value
Sometimes called the par value, this is the amount of money the investor pays to the company at the time of buying the bond. The face value is the amount you pay to purchase the bond. Sometimes, the value of the bond will change in secondary markets – such as when you are buying and selling on the open market. The value of the bond, which includes interest, is generally more than the actual face value. That face value doesn’t change, even if the interest does.
The Bond Yield
The yield, which is also known as the coupon, is the amount of interest that will be paid on the bond. Bonds can often pay the interest out to the investment holder every six months to a year. You only receive the interest in payments during these times, though, not the actual face value. Some bonds do have variable rates, which means the rate can adjust upward or downward based on market conditions.
The Bond Maturity
As the name implies, this is the date that the bond’s face value becomes due to be paid to the investor by the company. At this time, interest payments stop. The bond holder – you, the investor – receives the face value. This also marks the end of the agreement.
The Bond Issuer
This is the company or another entity that issued the bond and then makes the interest payments and face value payments to you. It’s not always a company, either. Governments can sometimes use bonds to raise funds.
Can a Bond Issuer Default and Not Make Payment on Your Bond?
This can happen. In some situations, the bond issuer may be unable to make payment when the face value becomes due. If this happens, the issuer defaults and the bond holder loses out on the funds put into the bond.
One way to hedge against this is to know the amount of risk the bond presents. You can do this by looking at the credit rating for the bond. Most of the time, if a bond has a low yield, that indicates that the company is a low risk for defaulting. Companies offering a higher yield – or interest rate – may be more desperate for the funds, and therefore have a higher risk for defaulting. It’s up to you to decide where your level of comfort is.
Which Type of Bond Is Right for You?
The next question you need to ask yourself is what type of bond you should invest in. There are several basic forms (and they are rather easy to tell the difference between).
The most common form, corporate bonds are those that are issued by a company. Companies can use them to raise funds, make purchases, expand, or do just about anything else they would like to offer. By comparison to other bonds, corporate bonds tend to be higher earners with a higher yield (remember, that means more risk).
Government bonds are much like a savings bond sold by the U.S. government. They are issued when the government agency has a need to raise money – sometimes to offset budget deficits, for example. Most governments will issue these from time to time. You can buy those form the U.S. but also from other countries.
Agency Bonds or Securities
Freddie Mac, Fannie Mae, and other government agencies may issue bonds as well. These are from the U.S. and tend to be used to help the organization raise funds to offset deficiencies or growth needs.
These are a type of government bond, but are sold on the local level and usually to accomplish specific tasks. Some local communities offer tax incentives to those who purchase municipal bonds.
Common Questions about Bond Investing
It’s always wise to speak to a financial advisor about your goals of investing, as well as how well bonds may work for you. Yet, there are some questions many people have with bonds.
Are Bonds the Safest Investment?
The safest investment is generally a savings account, which offers very little interest. Bonds are safer than other investments such as stocks, but they do carry some risk. As noted, companies can default on bonds. You can also buy a collection of bonds, otherwise known as an ETF, to minimize single bond risk.
Do Bonds Pay Too Little to Make Them Worthwhile?
It’s all about your risk tolerance. If you are looking to build a portfolio, including bonds, can be one way to add some stability to your investments. They do earn a significant return, and in some cases pay out every six months. It’s important to pick and choose those bonds that make your investment worthwhile.
How Can You Buy Bonds Now?
Like with stocks, you can buy them in several ways. Most commonly, you will buy them off the open market through a brokerage or through your financial advisor. Alternatively, you can buy bonds in your retirement accounts such as Roth IRA, IRA and even 401(k).
Are Bonds Right for You?
To make this decision, you really need to look at the amount of risk you wish to take on, the companies or agencies you hope to support, and your short term and long term goals. For many, this makes a solid and rather safer investment than others.