Throughout the years, you might have heard of bonds. But do you know what they are? Bonds can be very helpful when used correctly. To put it simply, a bond is a fixed income instrument, that is like a loan that’s given to a borrower from an investor.
Used by individuals, companies, states, municipalities and other organizations across the world, they are a popular method of getting money quickly. Within the paperwork for a bond, there will be details such as the principal of the loan and whether the payments have variable or fixed levels of interest.
How Do They Work?
Like a loan, the borrowing party will sign paperwork that states that they will pay back the bond within a set period of time. Until the agreed finish date, the borrower will make interest payments to the lender electronically. When the bond then matures, the debtor will repay the agreed principle (also known as face value). Some lenders might resell the bonds before the maturity date – in order to gain more income from the secondary market. Bonds can either be sold privately or publicly traded – when the latter occurs, the value can rise and fall until the end of the loan period.
The Bond Market: How Much Is It Worth?
You might be surprised to know that according to some statistics, the bond market is worth an incredible $41 trillion. One of the most efficient and liquid markets globally, approximately $500 billion in bonds is exchanged in this country every single day. These figures undeniably support the fact that millions of people and organizations worldwide are in debt.
Advantages of Bonds
- You will receive income from the interest payments: throughout the course of the bond, you will receive weekly, monthly or annual interest payments.
- They are almost risk-free: you will get all of the principal back at the end of the term and won’t lose your investment – unless the entity defaults.
- You can get a profit from reselling: if you resell the bond at a higher price, you can benefit from a profit.
- Money when you really need it: with the number of bonds available, you’re able to find the perfect one for your needs.
- Low down payments: often, the down payment that you’ll have to put down is low, meaning that you can usually afford to take on a bond no matter what your financial circumstances.
Disadvantages of Bonds
- They can pay out a lower ROI: over time, a bond can pay out a lower ROI than stocks do. If this occurs, you might not be able to earn enough to cover the cost of inflation.
- Organizations can default: if the company or individual fails to pay the interest or the principal at the maturity date, you could find yourself in a sticky financial situation.
- They can be confusing: bonds can be hard to understand – which is why it’s vital to seek professional guidance if you’re unsure as to which one is suitable for you.
- Interest rates can be high: after accruing a bond, you might be faced with high-interest rates. Therefore, it’s a good idea to compare and contrast different bonds, along with bondholders before you sign on the dotted line.
What Are The Different Types?
There are several types of bonds available. Each with different lenders, purposes, levels of risk, interest rates etc.it’s good to be aware of the key ones in case you need them in the future:
Perhaps the most known type of bonds is this country’s treasury bonds, bills and notes. Issued by the Treasury Department, they are directly used to set the exact rates for all of the other fixed-rate, long-term bonds.
Sold at auction, the funds accrued by them pay for the federal government’s operation. Fixed-income investments, they are often considered as the safest and most attractive type of bond as the government (and the world’s largest economy) guarantees them and ensures that they have low-interest rates.
Also resold on the secondary market, they are typically owned by almost every sovereign wealth fund, corporation, organization and institutional investors across the country. It’s important to know that there is, however, a difference between the different types of treasury bonds and this lies in the length of them:
- Treasury bills – typically last less than 12 months.
- Treasury notes – are typically issued in terms that last 2, 5, 7 and 10 years.
- Treasury bonds – typically last 30 years.
As well as bonds, the treasury also offers Treasury Inflation-Protected Securities. Similar to bonds (apart from the fact that their value increases with inflation), they typically last between 5 and 30 years.
Purchased by individual investors, savings bonds, similar to the above, are issued by the Treasury. Affordable due to the low cost of them, they are debt securities that help to fund the government’s borrowing needs. Also considered as a safe option due to the backing of the government, the longer the term the better the interest rate.
These types of bonds are ideal if you’re looking to save for a particular goal – such as your child’s education or for your wedding in the future.
Issued by a government agency, an agency bond are not typically guaranteed by the federal government. However, there are certain agencies, such as Freddie Mac and Fannie Mae that offer guaranteed bonds.
There are typically two types of agency bonds – a GSE bond and a federal government agency bond. For the latter, they are directly issued by either the Small Business Administration (also known as the SBA), Government National Mortgage Association (GNMA) or Federal Housing Administration (FHA). As they are considered to be less liquid than a treasury bond, it’s vital to know that they often hold a higher interest rate.
As GSE bonds aren’t backed the federal government, they hold a higher default risk and credit risk. Because of this, they tend to have a higher yield.
Held by various cities across the country, municipal bonds are attractive to investors as they are tax-free. They do, however, have a lower interest rate and are considered to be riskier. Because of this, cities occasionally default, putting bondholders out of pocket.
Issued by the local territory or government, they are typically used to finance projects for public requirements – such as schools, airports, roads, etc.
This type of bond is issued by organizations. As they are similarly not backed by the government, they are thought to be a risky choice. However, they tend to offer a high rate of return. Sold by a bank, there are three types that you should be aware of:
- Junk bonds (also known as high yield bonds) – these are issued to companies that have a major chance of defaulting. To help compensate for the risk, there often offer high-interest rates.
- Certificate of Deposit – similar to an individual bank bond, the borrower will have to pay back installments of interest and principal amount at the end of the contract.
- Preferred stocks – this type of corporate bond will require you to regularly pay fixed dividends.
Immigration Bonds are a type of payment that’s used as a guarantee. A bond that confirms that someone that’s been charged with a crime associated with immigration will attend all of their court hearings once released from immigration detention, it’s one that’s often forgotten about but that’s nonetheless important to mention.
Once the amount is set by either a judge or immigration agent, it’s vital that you seek an immigration bond to help cover the costs of the process.
Family bonds are another key type of bond that’s often forgotten about. However, they can prove to be very helpful in the long term. When you have a family, you want to protect them at all costs. A family bond is a tax-exempt bond that acts as a savings plan that helps to cover your family in case anything happens. It can also be used, however, as a way to put away money each month for your children’s future.
One that directly invests in shares and stocks, it provides an easy way to save money for the years ahead. Free from capital gains tax and income tax, it has the potential for growth and tends to be very affordable.
What Are The Different Varieties?
It’s critical that you’re aware of the different varieties of bonds available. Separated by the coupon payment, rate or type of interest, they are typically split into the following:
- Zero-coupon bonds – issued at a discount, this variety don’t pay coupon payments. Once the bondholder is paid in full, they will generate a high return; an example of this is a treasury bill.
- Convertible bonds – with a feature that allows bondholders to convert any debt accrued into equity, they are debt instruments that’s price is set by certain conditions such as the share price. With low-interest payments, you can make a great profit.
- Callable bonds – this variety can be ‘called’ back by the organization before the maturity of the principal. A risky type of bond as they tend to be called back when they are rising in value, they tend to be thought of as less valuable.
- Puttable bonds – this variety allows the bondholder to sell the bond back to the company before the maturity date. This, however, tends to be a forced decision as the issuer is made to repurchase the security. It’s also one of the most expensive types as the repurchase price is set at part value.