How do Bonds Work?
What is a bond?
Bonds are issued by corporations or the government in order to raise money. Corporations will issue bonds in order to raise funds to expand their business, and the government will issue bonds on the federal, state, or municipal level in order to pay for government expenses such as education, roads, etc.
A bond is a debt instrument, unlike stock which is an equity instrument. A debt is when one owes another for money that they borrowed. Equity is when one has part ownership in the company and is entitled to some of the profits of that company. Bondholders do not get dividends, only interest when maturity is reached or capital gains if sold before maturity.
Who can invest in bonds?
Anyone that has the money to buy a bond can invest in most bonds, unless there is some other limitation or agreement otherwise. If you want to buy a bond, you can go to treasurydirect.gov to buy government bonds or you can buy them from the bank. If you want to buy corporate bonds, you can buy them through a broker online or offline.
Why should you invest in bonds?
If you are young, you shouldn’t invest heavily in bonds, if at all. You can usually make more money through the stock market. As you get closer to retirement, you should invest more heavily in conservative bonds.
Not all bonds are low risk though, so be careful what you purchase. Low rated bonds, or junk bonds, can be just as risky, if not more than, stock and can still earn quite a bit if they don’t default. Only invest in government or high rated bonds if you are looking for minimal risk.
The best time to invest in bonds, if you are going to do so, is when interest rates are at their highest. The best time to buy stocks is when we are coming out of a recession because the stock market is looking up. The best time to buy bonds is during the way down when interest rates are up and before they go down.
How do Bonds Work?
So how exactly do you make money from bonds? Let’s say you buy 1 $1,000 bond with an interest rate of 4% and a maturity time of 10 years. You will pay $1,000 and this $1,000 will earn interest at a rate of 4% each year for 10 years. Then, at the end of 10 years, you will receive the $1,000 back, plus the interest if you didn’t receive interest each year.
There are also bonds available at a premium or discount. For example, you can buy a $1,000 bond at a discount for $960. You will earn interest and gain an extra $40 when you are paid back. If you buy a $1,000 bond for $1,030, you are paying a premium of $30 and get $30 less back.