What Are Bonds And How Do They Work

Bonds are, essentially, loans given to big organizations including governments and private corporations. Depending on the pre-determined terms set out by the issuer, the organization is typically obliged to pay all holders interest and/or repay the principal investment amount at a later date. One bond is normally a tiny portion of a huge loan.

The size of the loans that are required by these organizations is usually enormous, which is why they must borrow from more than just a few sources.

Advantages

Bonds are considered safer compared to stocks. They’re set up in such a way that holders cannot lose their capital unless the company goes bust. You can make money in two different ways. First, the interest payments will provide you with income and second, if you hold on until the date of maturity, you will get your principal back in a lump sum.

Many students who need to take out student loans use some of their money to invest in bonds in the hope they will get a regular return, which will help with their living expenses and to build a better future. They’re also an ideal opportunity for all investors who want to build a diversified portfolio of safe assets.

As a bondholder, you’ll get to enjoy a level of legal protection should the organization go bankrupt. In most countries, when a company goes bankrupt and is liquidated, the money is used to pay the people who hold the company’s debt.

Disadvantages

They typically pay out a lower return on investment compared to stocks. In many cases, holders do not receive enough to keep up with inflation rates, making bonds a not as good of an option for those that are looking to improve a retirement fund.

In addition, your money won’t be accessible until your holdings mature. That said; you will be able to sell them on before they reach maturity, but the market tends to be very illiquid, which forces holders to sell their assets at a loss.

Types

There are three types; municipal, corporate and U.S. Treasury. Municipal bonds are issued by state and local governments (also called municipalities) with the aim of raising capital for public projects such as the building and upkeep of hospitals, bridges and schools. When you invest in a corporate bond, you’re basically lending that specific company money.

You will not own a stake in the company so don’t confuse these holdings with shares. The company gets the cash it needs and you’ll get paid an agreed number of payments in return. These payments stop and the original sum is returned when the agreement expires, or reaches maturity.

The United States government issues U.S. Treasury bonds and the money raised is used to fund governmental initiatives. When you purchase a Treasury bond, you are lending money to the US government. These normally pay the least interest and they can only be cashed in once the date of maturity has passed. The money that’s raised is used to finance government spending and the maturity period can range from anything between 10 to 30 years.