May 25, 2024
A bond is a loan to an organization that is looking to raise a large sum of money to help pay for certain projects. These organizations can include corporations as well as governments at the federal, state and local levels. For example, local governments can issue bonds to help finance infrastructure projects like building roads, schools, and parks.
Bonds are considered a type of fixed-income investment because they typically provide a predictable stream of income in the form of interest payments throughout a specified period of time. There are many different types of bonds, but the basic categories that you will commonly come across include US Treasury bonds, municipal bonds, and corporate bonds.
Companies and government entities issue bonds when they need to borrow money. When you purchase a bond, you are basically giving a loan to the issuer (borrower). Think of it as a more sophisticated version of an IOU.
Bonds come with a specific set of borrowing terms. Under these terms, the borrower promises to pay you back for the original sum of the loan (principal or face value) by a certain date (maturity date).
In addition, you will also receive regular interest payments from the borrower. The interest payments are usually set at a fixed, pre-determined rate (coupon rate). But there are bonds with variable interest rates, and as the name implies, this means the interest rate can go up or down over time.
Let’s look at a basic example: If you buy a 10-year bond at the face value of $1,000 with a fixed 5% coupon rate, you will receive a total of $50 in interest payments ($1,000 x .05 = $50) every year until the bond matures. The frequency of the interest payments can be either semiannual ($25 every six months) or annual. When the bond is due in 10 years, you will also get back the original $1,000 you invested.
There are three main ways to buy bonds:
Just like cash, bonds come in a variety of denominations – for example, $1,000, $5,000 or more. Some bonds have a minimum purchase requirement. But you can start investing in US Treasury bonds with as little as $25.
Bonds are a basic but important building block of a balanced investment portfolio and can offer three main benefits:
Keep in mind that investing involves risk – no matter the type of assets you’re considering. While there’s potential for you to earn a return, there’s also a risk that you may lose money, including your principal. Here are some common risks to be aware of if you’re thinking about investing in bonds.
Good to know: A large part of investing is about figuring out how to properly balance risk and reward based on your willingness to take on risk; your capacity or ability to afford losses; and the time horizon over which you are comfortable having your assets invested.
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