Bond Basics: Understanding Fixed-Income Investments 1
When you buy a bond, you’re lending your money to the issuer in exchange for periodic interest payments and the return of the bond’s face value when it matures.
Bonds are essentially loans made by investors to borrowers, typically corporations or governments.
Bonds have been around for centuries, with governments using them to fund wars and infrastructure projects. The first recorded bond was issued by the Dutch East India Company in 1623. Since then, bonds have evolved into a crucial part of the global financial system, providing a stable and predictable income stream for investors.
Types of Bonds
Government Bonds
Treasury Bonds
Treasury bonds, or T-bonds, are issued by the U.S. government and are considered one of the safest investments since they’re backed by the full faith and credit of the U.S. government. They have long maturities, typically 10 to 30 years, and pay interest every six months.
Municipal Bonds
Municipal bonds, or munis, are issued by state and local governments to fund public projects like schools, highways, and hospitals. The interest earned on these bonds is often exempt from federal income taxes, making them attractive to investors in higher tax brackets.
Corporate Bonds
Investment-Grade Bonds
Investment-grade bonds are issued by companies with high credit ratings, indicating a low risk of default. These bonds provide a safer investment with lower interest rates compared to high-yield bonds.
High-Yield Bonds
High-yield bonds, also known as junk bonds, are issued by companies with lower credit ratings. They offer higher interest rates to compensate for the increased risk of default. They can be quite the gamble but can also offer higher returns.
Other Bonds
Zero-Coupon Bonds
Zero-coupon bonds do not pay periodic interest. Instead, they are sold at a discount to their face value and pay the full face value at maturity. This means you earn interest by the difference between the purchase price and the amount received at maturity.
Convertible Bonds
Convertible bonds are corporate bonds that can be converted into a predetermined number of the company’s equity shares. This gives investors the potential to benefit from the company’s stock price increase.
How Bonds Work
The Bond Market
The bond market is where investors buy and sell bonds. It operates over-the-counter (OTC) rather than on a centralized exchange, meaning transactions occur directly between parties.
Key Terms: Principal, Coupon, Maturity
- Principal: The amount of money originally invested or loaned, which is returned at maturity.
- Coupon: The interest payment made to bondholders, usually annually or semi-annually.
- Maturity: The date when the bond’s principal is repaid to the investor.
Bond Pricing and Yields
Bond prices and yields have an inverse relationship. When bond prices go up, yields go down, and vice versa. Yields can be measured in several ways, including current yield and yield to maturity (YTM).
Benefits of Investing in Bonds
Stable Income
Bonds provide regular interest payments, offering a stable income source, which is particularly appealing for retirees.
Lower Risk Compared to Stocks
Bonds are generally less volatile than stocks, making them a safer investment choice for conservative investors.
Diversification
Adding bonds to your portfolio can help diversify your investments, reducing overall risk.