Investment basics: how do bonds work?

Do you want to diversify your investment kit? Consider bonds. This type of securities includes a wide range of instruments with varying degrees of risk and income. Handled without care, bonds can really mess up your financial life. However, used wisely, they will become among the most valuable tools in your investment portfolio.

What do most people do if they want to purchase big-ticket items, for example a home or a car? They take loans. Similarly, businesses and governments use the same option when they need money to fund projects, pay bills, move into new markets, purchase new equipment and grow in general. However, the amounts they need can be much larger what a bank can lend. So another way for corporations and governments to borrow money is to issue bonds.

Thus a bond is like a loan: the issuer is the borrower, the bond holder is the lender. The issuer promises to pay back the amount they borrowed as well as an interest (the coupon) for the privilege of using the money. 

How much and how often you will receive interest depends on the terms of the bond. Typically, long-term bonds come with higher interest rate than short-terms loans. The interest payments are paid at specified intervals - once in 6 months, year, quarter or month. For example, if a $1000 bond is issued with a 5% interest rate, you will receive $50 interest each year, which might be obtained in $25 installments every 6 months.

A bond is generally issued with a $1000 face value. In return for purchasing the bond, the customer gets a piece of paper that states the original amount of loan, interest rate, how often interest will be paid, and the term of the loan.

The first person who buys the bond pays some amount of money (not always $1000), and the issuer promises pay off the principal, or original amount of the loan, when it reaches the date of maturity. However, not all investors hold bonds until maturity. Instead, they trade them like shares.

After the initial purchase, the bond can be sold and bought on the open market for more or less than the original price. When someone sells a bond at a price lower than the original amount, it is said to be selling at a discount. If a bond is sold at a price higher than the original amount, it is selling at a premium. 

What is the difference between stocks and bonds?

A bond and a stock are both a kind of investment. The main difference is that stocks are not loans. When you buy stock, you are buying a piece of a company. The returns represent a share in profits. Your income will reflect the success of a company. 

On the other hand, when you buy a bond, you are lending money to an organization. Bonds often offer a fixed interest rate, so no matter who holds the bond, they will earn exactly the same amount of money each year. That’s why bonds are also known as "fixed-income" securities and appeal to people who want to have a regular income from their investments. 

Stocks may rise in value, but they don’t actually generate income until you sell them. (Of course, there is an exception - stocks that pay dividends). Another difference is that bonds usually have a fixed term, or maturity, after which the bond is sold to the issuer, whereas stocks may be outstanding indefinitely.

Types of bonds

There are several entities that can issue bonds:
•    Government bonds
Governments issue bonds to fund various programs and pay bills. Bonds from stable governments, such as the United States, are considered a very safe investment. Bonds from developing countries, of course, are more risky. 
The U.S. government issues its own bonds from the Treasury and from several government agencies like the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corp. (Freddie Mac).
Government bonds that mature in less than one year are known as T-bills, bonds that mature in one to 10 years are called T-notes, and bonds that mature in more than 10 years are called treasury bonds. 

•    Municipal bonds
Municipal bonds, also known as "munis," are issued by states, U.S. Territories, cities, local governments or their agencies. The money is often used to finance projects such as schools, hospitals, airports, streets, office buildings, bridges, etc. 

Municipalities usually issue bonds when they need more money than they collect through taxes. Interest payments received by holders of municipal bonds are often exempt from the federal and state income taxes.

•    Corporate bonds
Corporate bonds are issued by businesses to help them fund their purchases or pay bills. While corporate bonds are more risky than government bonds, they offer higher interest rates. The disadvantage is that you will need to pay federal income tax on the interest you will earn.

Buying a bond 

First of all, it is important to consider how risky the bond is, especially when you are going to invest money in corporate bonds. Nobody wants to spend money for a low-yield investment if there are chances that the company will default or go out of business. 

Bond holders may lose much or all their money if the company goes bankrupt. Under the federal laws of many countries (including the U.S), bond holders are in line to receive the money from the sale of the assets of a liquidated company ahead of some other creditors. However, bank lenders, trade creditors and deposit holders may take precedence. 

There is no guarantee of how much money will remain to repay bond holders. For example, when the giant telecommunications company Worldcom went bankrupt in 2004, its bond holders received 35.7 cents on the dollar.

If you want to research the issuer's creditworthiness, find out its bond rating. The most popular third party organizations that research a company's financial situation are Moody's Investors Service and Standard & Poor's. They consider a company’s cash flow, debt, assets, liquidity and business plan for measuring risk. 

Every bond rating uses its own rating sc¬ale. They are typically indicated in letter grades to reflect the financial stability of the bond issuer. AAA rating means a safe, low-risk bond, and a D rating means a high-risk bond. Treasury bonds are rated the highest and "junk" bonds have the lowest rating.

There are several common ways to buy bonds:
•    Brokerage account
Bond brokers often act as intermediaries between buyers and sellers. Trough a brokerage, you can buy anything from a 10-year treasury bond to a 1-year junk bond issued by a company on the edge of bankruptcy. Bond commissions vary from brokerage to brokerage, so it makes sense to shop around before making your decision. 
•    TreasuryDirect

This program lets individuals purchase government bonds directly and avoid a brokerage. Investors can establish a single TreasuryDirect account that will hold all their treasury notes, bills, and bonds. 
•    Mutual funds

If you want to invest small amounts, sign up for an automatic investment plan which will transfer your money from a checking account to your investment account. However, keep in mind that mutual funds have drawbacks, such as ongoing expenses and a potential loss of principal.