A bond is an IOU issued by governments, companies or other financial organizations against the money you lend them. While buying stock in a company makes you part-owner of the company, buying bonds makes you a creditor. Investing in bonds is considered an important part of creating a diverse portfolio for long-term gains.
How Do Bonds Work?
When you buy a bond from the government or a company, you are loaning them a certain amount for which they will pay you an interest or ‘coupon’. The interest is paid every year and the principal amount is returned to you at the end of the bond duration. The value of the bond at the time of purchase, known as the Par Value, is what you receive at the maturity of the bond.
Benefits of Investing in Bonds
Although they bring lesser returns when compared to stocks, bonds are more stable and safer than stocks. Here are a few other benefits of investing in bonds:
Invest with smaller amounts – Bonds are available in denominations as small as $50, making them affordable even for people with a small income.
Double your investment – You can purchase the series EE bond issued by the US government for half its value and get the full face value amount at maturity, doubling your investment.
Secure investment – Bonds issued by the government are secure as they are guaranteed by the Federal Government.
Tax exemption – Interest earned on many bonds is excluded from state and Federal taxes if it’s used for certain specified expenses like college tuition.
Types of bonds
Following is a list of the different types of bonds issued by government organizations and private companies.
Government Bonds – The US government bonds are the safest form of investment because the interest and the principal are guaranteed by the Federal government.
Treasury Bonds – Issued by the treasury department of the US government, treasury bonds are available in the denominations of $1,000 and earn an interest every six months.
Zero-coupon bonds – Also known as “strips” or “zeroes”, these bonds are also issued by the treasury department at a highly discounted price and come with a duration ranging from six months to 30 years.
US savings bonds – The US savings bonds are the safest investments to put your money in. Issued by the Federal government, these bonds are excluded from your taxable income. The Series I bonds, which are inflation indexed treasuries, have an interest rate linked to inflation and allow your bond to keep pace with price rise.
Municipal bonds – A favorite with a lot of investors, municipal bonds or munis are offered by the municipalities or the local governments. Available in a minimum denomination of $5,000, these bonds are available for a period of one year to 30 or 40 years.
Corporate bonds – Issued by companies and other non government organizations, these bonds pay an interest that is taxable. They are issued in $1,000 denominations and have duration between one and twenty years. These bonds come with a risk factor as the returns depend on the credibility of the company issuing them.
Foreign Bonds – A foreign bond, issued by a foreign entity in foreign currency denominations, can be traded in both local and foreign markets. These bonds carry a potential risk due to fluctuating currency exchange rates.
Junk Bonds – Bonds that are rated ‘BB’ or lower because of their high default risk are called junk bonds. These bonds offer at least 3-4 percent higher interest rate when compared to the other bonds, but can be quite risky.
The bond term determines how soon you can get your returns and it also has an effect on the interest rate that the bond offers. You can decide to go for a long-term or a short-term bond depending on the returns you expect and when you will need the money.
Next Chapter: Risks Associated With Investing In Bonds