Most people know about stocks. The stock market is what most people think of when it comes to investing, alongside real estate. Bonds are less prominently considered, which is a shame. Delving into the bond market can be a great long-term supplement to a financial plan.
Since bonds aren’t exactly everyone’s favourite investment option, the basics of them can be a bit obscure. Presented here is a simple primer on what they are and how they work.
Bonds represent debt obligations. When a company or any other organization issues a bond, they are receiving a loan.
As a loan, it must be repaid over time. The loan also accrues interest over time, paid to the lender. It is these interest payments that provide the profitability of a bond.
So if you buy a corporate bond, you are giving money to the corporate entity. You do not own anything. However, the amount you provide grows due to the interest. When you are finally paid back, you get more than what you put in.
Governments and corporations both use bonds to raise funds. While these entities can go to a bank for the money they need, there is a rule that applies. The bigger an organization is, the more money they need – and the lower the odds that bank loans can cover the costs.
This is particularly done during a time of war or massive spending programs, for governments. Infrastructure, public services, and the like all require funding that taxes might not be able to fund in full.
For companies, bonds are issued when there is a need to raise funds. These funds might be used to help fund an expansion of operations, hire new personnel, or enter intensive research and development.
A public debt market allows thousands of individuals to become investors. They become a small part of the overall capital required for a project or endeavour. They also provide the option of selling the bonds, allowing for a potential immediate profit rather than the later one the bond itself gives.
The issuer of the bond pays the investor in both the amount of the bond and the interest. These payments come at a set rate and schedule, determined ahead of time. This is separate from the maturity date, which is when the amount borrows – the face value – is repaid.
Bonds are a fixed income security because the interest payments are set and the investor knows the exact amount that is incoming. Obviously, the bigger the amount you loaned out, the bigger the interest payments are, based on the schedule.
However, like any other investment, bonds incur an opportunity cost. Any money you use to secure a bond is money that can no longer be spent on other investments.
Bonds are low risk but demand patience. There is no way to recoup the cost of a bond before it matures unless one decides to sell it. It isn’t reliable as the sole source of one’s income, but it can help diversify a portfolio.