A bond represents a loan between a lender – usually a corporation or the government – and a borrower. The specifics of a bond include details that outline the bond amount, interest payments, and the dates when the borrower must make those payments.
Bonds are fixed-income entities, which means borrowers typically pay a predetermined interest rate to lenders.
Read on to learn more about the various types of bonds, how they function, and their advantages and disadvantages.
Understanding how bonds work
Alongside stocks and cash, bonds are one of the main assets that investors frequently handle because each entity is tradable.
Typically, borrowers purchase bonds when they need to fund specific projects or settle debts. Investors who give out these loans go by several names: debtholders, bondholders, or creditors. Borrowers are also known as bond issuers.
The bond includes information regarding the loan amount, interest payments, and when each payment is due. The loaned funds – or the bond principal – must be repaid by a specific date, known as the maturity date. The annual interest rate paid on a bond – or the bond coupon – is an investor's monetary compensation for having lent their money.
Bonds typically begin at $100 or $1,000. Upon acquisition, borrowers may resell the bonds to another party, which is a relatively standard practice. Investors can buy back the bonds they've loaned, too.
Characteristics of bonds
All bonds share four primary characteristics:
Face value: This refers to the bond's worth by its maturity date. Lenders use this value to determine a bond's interest rate.
Coupon rate: Typically expressed as a percentage, this refers to the interest rate that the borrower will pay.
Maturity date: This is when the borrower will repay the bondholder the bond's face value in full.
Coupon date: The coupon date is when interest payments are due, usually twice a year.
Types of bonds
The U.S. Treasury issues government bonds, which fall into three subcategories: bills, notes, and bonds.
Bills are federal bonds issued with a maturity date of a year or less. Notes are bonds with a maturity period of one to 10 years. Bonds take longer than 10 years to reach maturity.
The federal government usually earns five percent in returns per year through the distribution of bonds. The loaning and acquisition of federal bonds is a public endeavor. In comparison, the handling of other bond types is a private affair.
The distribution of federal bonds is a form of sovereign debt.
Also called munis, state and city governments issue these bonds. Municipal bonds help fund local developmental projects like building new schools or improving roads. These bonds can have a short-term repayment period of one to three years or a lengthier repayment period of up to 10 years.
Finally, depending on the circumstances, borrowers may receive tax benefits.
Issued by companies, most businesses prefer this type of loan because corporate bonds tend to have lower interest rates than bank loans.
Unlike stocks, acquiring corporate bonds doesn't mean you own shares in the company.
Similar to government bonds, corporate bonds fall into two categories: high-yield bonds and investment-grade bonds.
A high-yield bond suggests a borrower has a weak credit score, and therefore the borrower must pay a higher interest rate to justify the lender's risk. An investment-grade bond is the opposite and comes with lower interest fees because the borrower has proved they are less likely to default on repayment.
Agency bonds – or agency debt – are loans that government-sponsored organizations issue. Local and state taxes rates do not apply to the majority of these bonds.
The pros and the cons of bonds
The first benefit of issuing a bond is that you profit by way of interest payments. It's a type of fixed income because payment periods occur regularly. As a result, owning bonds can be a smart strategy when saving for retirement.
Secondly, if the bond reaches maturity, the borrower will repay the entirety of your loan. Bondholders can also resell bonds at a higher price.
You'll earn less return by owning bonds than if you own stocks, as bonds typically have lower interest rates. Bonds also run the risk of default, meaning that the borrower does not repay the loan.
While fixed earnings can be a good form of steady extra income, they can also cause drawbacks because there is no potential for your money to grow exponentially over time.
What are bond yields?
Bond yields refer to a bond's evaluation. For example, a high-yield bond – also known as a junk bond – is not necessarily a wise investment. However, these bonds have the potential of making the highest returns if you are comfortable with taking a significant risk.
How do you price a bond?
Bond prices fluctuate according to market trends – such as supply-and-demand – and interest rate thresholds. The sensitivity of a bond is known as its duration. It is crucial to note that in this context, bond duration has nothing to do with time but refers to a bond's susceptibility to economic phenomena.
Generally speaking, when interest rates rise, bond prices drop.
Additionally, a bond's yield-to-maturity, or YTM, can also calculate a bond's price. YTM refers to the total return expected from a bond if it reaches maturity.
Is there a risk with bonds?
There is some risk associated with handling bonds. A bond's riskiness depends on the borrower's credit history. The safest bonds to invest in have an “AAA” rating, while the riskiest ones are rated “B” or “C.”
Ultimately, investing in bonds is yet another strategy to earn additional income. But, regardless of how you make that money, handling it wisely and having easy access to it is just as important.
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