Understanding Bonds: A Beginner’s Guide

When people first start thinking about their investment options, they bring terms such as stocks, mutual funds, or bonds to the fore. Of those, investors tend to include bonds in many investment portfolios because they approach investment systematically. Grasping how bonds work can greatly help those not versed in financial planning clarify their dilemmas.

Bonds represent a loan by an investor to a borrower. Corporations, municipalities, or governments usually act as borrowers. Thus, when one buys a bond, they lend money to the issuer in exchange for periodic interest payments at set dates and a promise to return the bond's face value on maturity.

How do Bonds Function?

A bond comes complete with terms, including principal (or face value), maturity, and interest rate. The issuer agrees to pay back the principal at maturity of the bond. The interest rate governs the periodic payments that the issuer makes to the bondholder.

Bonds vs. Other Investments

Bonds provide income, but they do not normally confer ownership interest or voting rights to the investor. Price volatility in the case of bonds is less than that of stocks. In general, bonds provide lower expected returns than other riskier options but may provide consistent income and capital protection. Hence, investors frequently see bonds in a diversified approach.

Types of Bonds

There are different types of bonds, which are defined below:

Government bonds

Central governments worldwide issue these bonds and often classify them as stable fixed-income securities. In the United States, Treasury securities are in the form of Treasury bills (short term), Treasury notes (medium term), and Treasury bonds (long term). Investors must pay federal taxes on the interest accrued on Treasury securities, while they may exclude it from state and local taxes.

Municipal Bonds

Local governments, municipalities, or states buy municipal bonds to assist in funding various public projects, such as roads, schools, or water systems. There are two types of municipal bonds: general obligation bonds and revenue bonds. The taxing power of the issuer backs general obligation bonds, while revenue bonds get paid from the revenues generated by the specific projects.

Corporate Bonds

Corporations raise money for expansion, research, or restructuring by issuing bonds. These bonds usually have higher coupon rates than government or municipal bonds because of greater credit risk. Credit rating agencies (Moody's, S&P, and Fitch) assign ratings based on the financial health of issuers of corporate bonds to provide a relative measure of risk. Corporate bonds may take various forms, such as secured and unsecured. Secured bonds are backed by specific assets of the company. Unsecured bonds, also called debentures, do not get backed by specific assets, only by the creditworthiness of the company.

Convertible Bonds

Investors can swap convertible bonds, which are corporate bonds, under certain conditions for an established number of shares of a company's stock. This option allows bondholders the chance to participate in the growth of that company, even as they continue to earn fixed interest. Nevertheless, convertible bonds usually pay less interest than similar bonds that are not convertible.

Zero Bonds

Unlike the other bonds described earlier, zero-coupon bonds do not pay periodic interest rates. Instead, they get issued at a discount and pay full face value upon maturity. Investors use zero-coupon bonds for long-term goals like education or retirement. Thus, the price appreciation serves as the yield for the investor, though taxes may apply annually on the imputed interest even without a cash payment.

Risk Related to Bonds

As with any investment, investors face risks with bond investments. Interest rate risk occurs when interest rates rise, leading to a drop in the prices of existing bonds. Credit risk, especially for corporate bonds, poses the possibility that an issuer may default on payment. Inflation risk refers to the possibility that inflation could render the interest payments on a bond less valuable. Keeping these risks in mind will help investors make the correct choice when picking suitable bonds for their portfolios.

Spreading investments across various types, maturities, and credit qualities of bonds will help mitigate these risks. To achieve diversification, many investors find it useful to invest in bond mutual funds or exchange-traded funds (ETFs) rather than picking individual bonds.

Conclusion

Understanding bonds provides a better start for beginners in making a sound financial plan. Bonds offer income, stability, and structure.