Today’s financial literacy discussion focuses on bonds.
Did you know that lots of people who own stocks, don’t own any bonds? In fact, some don’t even know what they are.
But, owning bonds in your portfolio can be a very good idea.
Have you ever bought a bond? Yes? No? If you have, what type of bond have you bought? Let me know in the comments.
What is a bond?
A bond is a debt. Companies or governments are the ones taking on this particular debt. So, the investor loans the company or government money in exchange for the bond.
For example, a company or government issues a bond as a way to borrow money. It is an alternative to borrowing money from a bank. Instead, the company or government borrows money from individual investors who become the bond holders.
How do investment bonds work?
A company or government issues a bond in exchange for a loan. In exchange, the investor then receives regular payments. Then at the end of the bond period, the investor receives their principal back.
What are the 3 types of investment bonds?
Based on some categorizations, there are 3 main types of bonds. The three main types of bonds are corporate bonds, high yield bonds, and municipal bonds.
- Corporate Bonds are high quality bonds issued by corporations.
- High-Yield Bonds are corporate bonds that have a lower credit rating. They are rated BB+ or lower. This means that they are riskier than Corporate Bonds.
- Government Bonds are bonds that are usually issued by the federal government, but include from the federal government to states, counties, and cities.
What are municipal bonds?
Municipal bonds are government bonds that are issued by cities, counties, and states.
Often, these are called “munis.”
Municipal bonds are often issued to raise money for things such as: to build things for the public, such as roads and schools.
This type of bond is free from being federally taxed.
How are bonds rated?
Bonds are rated by credit rating agencies such as S&P.
S&P’s rating scheme uses capital letters to indicate the rating of a company.
The ratings range from AAA (the best) down to D (the worst).
Everything BBB- and above in the S&P rating is considered investment grade.
A “AAA” rating is considered a prime company. These companies are highly likely to be able to repay your bond investment.
“D” rated companies are highly unlikely to be able to repay your bond investment. Because D-rated bonds are very risky, they are likely to pay a high rate of interest.
What are corporate bonds?
When people say corporate bonds, they usually mean high quality corporate bonds (as opposed to high yield corporate bonds, also known as high yield bonds).
Companies issue bonds to raise money.
The lowest S&P rating that a corporate bond can have is BBB.
Anything below BBB would be considered a high yield bond, which is another category of bonds.
What are government bonds?
Government bonds are bonds that are issued by the government. Not surprisingly, most government bonds are considered safe, and the best have a AAA S&P rating.
The bonds can be purchased directly from the government website.
What are high yield bonds?
High yield bonds are corporate bonds with high yields. But, they also have high risk.
These bonds are rated below BBB.
High yield bonds are also called junk bonds.
They do not have investment- grade ratings.
What are junk bonds?
Junk bonds are bonds that have a low credit rating from the credit agencies, such as S&P.
They have high interest rates.
But, junk bonds also have high risk.
Using the S&P rating, junk bonds have a BB+ or lower rating.
Therefore, they are not investment grade investments.
What is one disadvantage of a junk bond?
Junk bonds are highly risky. That is why they offer higher interest rates.
The risk is that the investor may not get their money back.
Why do companies issue bonds?
Companies need to raise money. So, they issue bonds to get more money to finance their projects. It’s an alternative to issuing more stock, which would be considered financing via equity. Issuing more equity increases the number of people with whom profit must be shared.
When a company issues bonds, they are financing via debt.
When there are outstanding bonds, the company pays those bond-holding investors interest. But, no matter how profitable the company becomes, the investor only gets the pre-set amount of interest. When the bond is mature, the company then returns the principal to the investor.
How do I know which bonds to buy?
The first thing to consider is the rating (like the S&P rating), and the issuer. Also, you want to consider your goals of purchasing the bonds.
So, I suggest that you do your research on any bonds that you are considering, and to discuss your goals with your investment advisor.
What are the benefits of investing in bonds?
Bonds provide fixed, predictable income. In other words, bonds provide an income on which you can depend. The income comes in the form of interest payments until maturity.
At maturity the principal is returned to the investor.
The interest from municipal bonds is usually tax-free at the federal level. Municipal bonds are also often tax-free for the residents who buy municipal bonds from their own municipalities.
What is the most important thing to consider when buying a bond?
The most important things to consider when buying a bond are:
- the issuer (the company or the government), and
- the credit rating of the issuer
How do I invest in a bond?
You can buy corporate bonds through a brokerage house.
Additionally, you can buy government bonds through a broker or directly through Treasury Direct.
A link to Treasury Direct can be found at the end of this post.
Can you lose money investing in bonds?
Yes. In fact, you can lose money investing in stocks.
Two ways that you can lose money are:
If the issuer defaults.
If you are forced to sell the bond before it matures.
Key Bond Takeaways
- A bond is a debt issued by a corporation or a government.
- A bond is a debt issued by a corporation or a government.
- Bond investors receive regular payments, and at the end, their principal is returned to them.
- The 3 main types of bonds are: corporate bonds, high-yield bonds, and municipal bonds.
- Corporate Bonds are issued by companies.
- High yield bonds are high yield corporate bonds but unfortunately, they are highly risky.
- Government bonds are issued by governments, from the federal government to states, counties, and cities.
- Bonds are issued as a way for an entity to raise money for financing.
- Some benefits of buying bonds are they offer dependable interest, and municipal bonds are free from federal taxes.
- You can invest in a bond by going through your broker, or directly through the government for government bonds.
- Bond investors receive regular payments, and at the end, their principal is returned to them.
- The 3 main types of bonds are: corporate bonds, high-yield bonds, and municipal bonds.
- Corporate Bonds are issued by companies.
- High yield bonds are high yield corporate bonds, but unfortunately, they are highly risky.
- Government bonds are issued by governments, from the federal government to states, counties, and cities.
- Bonds are issued as a way for an entity to raise money for financing.
- Some benefits of buying bonds are they offer dependable interest, and municipal bonds are free from federal taxes.
- You can invest in a bond by going through your broker, or directly through the government for government bonds.
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Also, please note: I am not an investment advisor. Always do your own due diligence and research before investing. Check with your own investment advisor.
The information shared here is not intended as financial advice, just entertainment and encouragement.
Here is a link to Treasury Direct, if you want to check out a place to purchase federal government bonds: https://www.treasurydirect.gov