Bonds are loans that every investor can make to governments, corporations, municipalities and financial institutions for example.
These are considered very safe investments that give lower profits.
Instead of borrowing from a bank, the borrower raises money directly from investors. When you buy a bond, you are not buying shares of ownership in a company. You become a creditor to someone else!
The bond issuer guarantees two things:
- Periodic interest payments;
- Repayment of the original loan at maturity;
The original loan amount is called the “principal” or “face value”.
An example is a $1000 U.S. Treasury Bond with 5% interest and 10 years to maturity.
With this investment you would receive $50 per year in interest and your principal sum of $1000 is returned after 10 years when maturity (the end) is reached.
Government often issue bonds to fund infrastructure projects, to finance deficits and to manage economic cycles. Corporation often issue bonds to be able to invest more money into their business or to refinance debt.
Bonds are usually cheaper than bank loans for these governments and corporations.
Bond prices tend to move in the opposite direction of interest rates!
If interest rates rise, bond prices will most likely fall. If they fall, bond prices will most likely rise.
This is because new bonds will be issued with the new interest rate. If this interest rate is higher, these bonds will be more attractive to investors. This is why bonds with lower interest would need their price to be lowered to be as attractive as the newly issued bonds.
There are different kind of bonds available:
- U.S. Treasury Bonds (these are considered the safest assets);
- Municipal Bonds;
- Corporate Bonds;
- International Bonds (in countries other than the U.S.);
Yields and taxes can vary widely on all of these different bonds. Some bonds are tax-free!
Bonds are rated by financial institutions based on their quality, like AAA (which is the highest rating), AA, A and BBB. Everything below this means highly speculative with potential high yields. These low-rated bonds are also called “junk bonds” and chances of default are high.
Bonds are most often used to stabilize investment portfolios and reduce market volatility, but once again, the yields on bonds tend to be pretty low!
They are also attractive during market recessions, in which they guarantee some form of income. Bond prices often rise during recessions due to more buyers.
We do not recommend investing in bonds because there are much better yielding options to stabilize your investment portfolio available on the internet in our opinion!
We will post a blog article about this soon.