A bond is a fixed income investment in which an investor loans money to an entity which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are generally issued by the government, companies, municipalities or states to meet their expenditure or debts.
The act of buying a bond is indeed that you are lending the institution selling the bond your money with the agreement that the institution will repay your loan to them at the end of a period called maturity date that is set when you buy the bond. You also get to receive some interests on your loan each year while the bond tarries.
There are different bond options available to an investor, and you need to know which is right for your unique situation as well as the dangers presented by owning different types of bonds.
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Types of bonds
There are different types of bonds one can invest in, and such investment options are made based on what the investor has in mind. They include;
- Corporate Bonds
Cooperate bonds are bonds issued by corporations to solicit funds to further their businesses. By lending money to companies, you can often enjoy higher yields than you get on other types of bonds. Though corporate bonds tend to offer higher interest rates than other types of bonds, but that interest is taxable at both the state and federal level.
- Municipal Bonds
Municipal bonds also called muni bonds, are issued by states, cities, and other such localities to finance public projects or offer public services. Investing in municipal bonds gives you tax exemptions under certain situations. These bonds are good for investors who are in a middle to high tax bracket. By investing in your local schools, hospitals, and municipalities, you can not only help your community but also make money from your generosity.
Municipal bonds come in two varieties: general obligation and revenue. General obligation bonds are backed by the full faith and credit of the issuer, which means that if a city issues general obligation bonds, it can levy taxes, sell assets, or do whatever that is necessary to repay bondholders on schedule. Revenue bonds are backed by the income streams tied to them. If a city issues revenue bonds to build an express toll road, the toll proceeds can be used to pay back bondholders. Both types of municipal bonds pay interest that’s exempt from federal taxes, and if you buy municipal bonds issued by your home state, you can avoid state and local taxes as well.
- US Savings Bonds
U.S. savings bonds are debt securities issued by the U.S. Department of the Treasury to help pay for the U.S. government’s borrowing needs. U.S. savings bonds are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government.
You need to get a broad education on savings bonds, their history, considerations before adding them to your portfolio, and tax notes.
- Treasury bonds
Treasury bonds or T-bonds, are issued by the U.S. government. The interest you receive from T-bonds is taxable at the federal level, but it’s exempt from state and local taxes. Treasury bonds have a maturity of 10 years or more, and are backed by the full faith and credit of the U.S. government. For this reason, they’re considered virtually risk-free. However, they don’t offer the same (higher) interest rates as corporate bonds.
- Series EE Savings Bonds
The Series EE Bond is a non-marketable, interest-bearing U.S. government savings bond that is guaranteed to at least double in value over the initial term of the bond, typically 20 years. Most Series EE bonds have a total interest-paying life that extends beyond the original maturity date, up to 30 years from issuance.
These unique bonds offer tax advantages for education funding, the guarantee of the United States Treasury, a fixed rate of return for up to thirty years, and more.
- Convertible bonds
Convertible bonds are debt instruments with an embedded call option that allows bondholders to convert their debt into stock (equity) at some point if the share price rises to a sufficiently high level to make such a conversion attractive.
Advantages of investing in bonds
Bonds are securities that are similar to loans and they are issued by governments and corporations around the world to finance new projects, maintain ongoing operations, or refinance other debts. The issuer typically makes regular interest payments, and repays the full investment at the end of a set period of time, at which point the bond typically reaches “maturity” and the investor’s principal is returned, plus any accrued interest.
Bonds have the following benefits;
They are relatively safe: One advantage of putting bonds in your portfolio is that they’re a relatively safe investment. Bond values don’t tend to fluctuate as much as stock prices, so they’re less likely to make you lose your investment.
Predictability: Another benefit of bonds is that they offer a predictable income stream. Because bonds pay a fixed amount of interest twice a year, you can generally rely on that money to come in as expected. Municipal and Treasury bonds offer the additional benefit of paying tax-exempt interest to varying degrees.
It helps to generate income: The interest payments that bonds offer can help investors build an income stream that can be reinvested or used to manage cash-flow needs—either supplementing existing income or creating a source for income in retirement.
It preserves capital: Repayment of the original investment in the bond can help provide reassurance to investors who are concerned about protecting capital or meeting intermediate-term financial needs, such as college tuition or a down payment on a new home. For more immediate financial needs, cash savings, money markets, or other short-term options may be more appropriate.
It’s less volatile than stocks: Because issuers of bonds generally make interest payments and repay principal, investment-grade bonds can be less volatile than stocks. As a result, bonds can provide the potential for diversification, and help investors interested in lowering their portfolio volatility.
Problems associated with bond investment
Bonds have always had the reputation of being safer than stocks, but this is not always true. This mode of investment carries with it some real dangers than can affect the investor if they don’t know how to reduce the risk. Some of the risks that come with bonds include;
Bond spreads: Bond spreads are a hidden commission charged to you when you buy or sell bonds. They can sometimes be as much as hundreds of dollars every time you buy a single bond. To have a safe investment, you must learn how to minimize bond spreads.
Bond duration: It should be noted that the longer the period of your bond investment, the more it is susceptible to violent fluctuations. For example, if you buy a bond that matures in 30 years, it could fluctuate far more violently than a bond that matures in two years. In some cases, bonds with high durations can actually fluctuate as much as stocks. This on its own portends a serious danger to longer term bond investments.
Foreign Bonds problems: Despite what you are told, you should know that investing in bonds outside your own country comes with its own unique set of dangers. This is because your investment is subject to the dictates of another government. You would have to seek expert advice if you want to go this route.
It may have transparency issues: One other drawback of buying bonds is that, due to the way they trade, there’s less transparency in the bond market. As such, brokers can sometimes get away with charging higher prices, and you might have a harder time determining whether the price you’re quoted for a given bond is fair.
Call Risk: Call Risk refers to when the issuer of a bond calls out and retires the bond, thus buying back all the bonds from people who bought it before the maturity date has reached.
How to invest in bonds
Bonds aren’t traded publicly, but rather are trade over the counter, which means that investors must buy them from brokers. The Financial Industry Regulatory Authority (FINRA) regulates the bond market to some extent by posting transaction prices as the data becomes available, but investors can sometimes experience a lag in getting that information.
Here are steps to take if you want to invest in bonds.
- Set up a brokerage account
Bonds are usually purchased through a brokerage account, as such, if you want to invest in bonds; you have to first set up such an account. A brokerage firm is usually in communication with governments and companies that want to issue debt, so they can tell you which ones are available. Again, brokerage firms also have access to the markets where bonds trade in the secondary market.
If you feel knowledgeable enough to direct your investment by yourself, you can set up an account online by going to the website of a brokerage firm such as Charles Schwab, Fidelity or TD Ameritrade. You can also choose to work with an advisor if you want.
Another way you can set up a brokerage account is to go to your local bank or full service firm. Be sure to check out all these alternatives so as to find one that has acceptable fees and rates.
When you finally find the ideal place to open your brokerage account; you will need to complete a new account form. When the account is approved, the investor can transfer funds into the account to purchase bonds.
- Consider your bond timeframe
Once your account is set up, you are now free to purchase the bonds you need. But while doing this, you have to note your timeframe for investing. If an investor has a specific time period for investing, they can select bonds that mature near that future date. Bonds can typically mature from a few years to 30 years, so while investing, you need to consider when you will need your money back.
One thing you have to note about bond timing is that the longer until maturity, the higher the interest rate offered on the bond, so have this in mind while investing.
- Check the credit rating on the bond
Credit rating refers to the ability of the bond issuer to make all required interest payments and to repay the principal balance on time. This is one of the important things an investor needs to determine before purchasing a bond. The higher a bond’s rating, the more expensive that bond may be.
Highly rated bonds are usually known to offer a lower interest rate. That then means that if a bond has a poor rating, it will have to offer a higher interest rate to attract investors. The higher interest rate compensates bond buyers for taking more risk. The bond with the lower bond rating is judged to have a higher risk of not paying interest and principal payments.
- Make your order
Once you have decided on which bond to purchase, the broker and your timeframe, you can now place an order for your bonds. Your brokerage firm would help you to do this. If new bond offerings are available, you can get them, but more often than not, your bond can be purchased in the secondary market. This essentially means that the investor is buying the bond from another investor.
Once the deal is done, you will receive a sort of confirmation from the brokerage firm. This confirmation would contain details of the purchase and should be kept safe. If an investor decides to sell the bond before maturity, the brokerage firm will quote a sale price. That price is based on demand in the secondary market. When an investor places a sell order, the brokerage firm will deliver securities to the buyer. The investor also receives a trade confirmation for a bond sale.
How to make money from bonds investments
There are two identifiable ways investors make money from bonds. The first is that they tend to hold the bonds until their maturity date and collect interest payments on them. Bond interest is usually paid twice a year.
The second way to profit from bonds is to sell them at a price that’s higher than what you paid for them initially. For example, if you bought $10,000 worth of bonds at face value — meaning you paid $10,000 — then sell them for $11,000 when their market value increases, you can pocket the $1,000 difference.
How to calculate bond interest
Before you can think of calculating your bond interest, you have to know the exact face value of your bond. Generally, the face value of a bond is either $1000 or a multiple of the same.
Then, you have to check the Bond Coupon rate percentage of your bond. The coupon rate percentage of the bond is set when the bond is bought and remains unchanged for the entire period of the bond.
You now have to multiply the face value and the coupon rate percentage of the bond. The result you will get is the annual interest that you will receive from your bond investment.
For example, if the face value of the bond you purchased is $1000 and the coupon rate percentage of your bond is 5%, then the annual interest you are paid for the bond is $50. If the interest is paid to you on an annual basis, then you will receive $50 every 12 months. If the interest is paid every six months, then you will receive $25 every six months or in case the interest is paid to you monthly, then you will receive $4.16 every month.
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