Investment in bonds is essentially loans that either a company or the government takes from investors whenever they need to raise money for funding particular projects, for example, the building of a major road.
In exchange for these loans, the issuer agrees to make interest payments to the investor for a specific period. Bond investors receive periodic payments based on the interest rate at which the bond was sold.
Upon maturity of the bond, the principal amount is paid back to the investor.
How Bonds Work
For example, you might buy a 10-year, $10,000 bond paying 3% interest. The issuer, in exchange, will promise to pay you interest on that $10,000 every six months, and then return your $10,000 after 10 years.
Types of Bonds
- Corporate bonds: Corporations issue these bonds to raise capital for business-related operations such as research, product development, or expansion. They 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: States, cities, and other such localitiesissue these bonds to finance public projects or offer public services such as building a community hospital. However, the interest on municipal bonds is lower than that from corporate bonds.
- Treasury bonds: The government issues these bonds. They usually have a longer maturity period, for example, 10 years or more. They are considered virtually risk-free as they are backed by the government. However, they don’t offer the same (higher) interest rates as corporate bonds.
Evaluation of Bonds
How then, would one know the best bond to take up? One of the best approaches is to check the bond ratings.
Bond-rating is a score which measures the financial strength of the institution that is issuing the bond.
There are three major bond rating agencies; Standard & Poor’s, Moody’s, and Fitch. These agencies use a combination of letters, numbers, and symbols to indicate the creditworthiness of bond issuers.
The higher a bond’s rating, the safer an investment it is. However, highly-rated bonds also tend to offer lower interest rates than bonds with lower ratings because investors are rewarded for taking on the additional risk associated with poorly rated bonds.
Advantages of Investment in Bonds
- They are a relatively safe investment because their values don’t tend to fluctuate so much.
- The income stream is predictable, thus makes it easier to plan.
- Bonds offer a chance to invest in communities.
Disadvantages of Investing in Bonds
- They require one to lock their money away for extended periods of time.
- They’re not completely risk-free. If an issuer defaults on its obligations, one risks losing out on interest payments, getting their principal repaid, or both.
- The return on investment one gets from bonds is relatively low compared to other kinds of investments such as stocks.
- There’s less transparency in the bond market which may result in brokers charging higher prices.