What is a Bond? Types and Benefits of Bonds
A bond is a type of fixed investment that pays interest and has an agreed maturity date. The term "bond" can be used to describe any debt security, including government bonds, corporate bonds, and mortgage-backed securities. Bonds are usually bought with borrowed money at low rates of interest in order to earn more income than would otherwise be possible on cash savings alone.
A bond's principal value will generally rise over time as the issuer repays its debts from future earnings or other sources. This means that investors who buy bonds today may benefit if they hold them until maturity, rather than selling them before then. However, this also makes it harder for new buyers to get into the market when prices fall.
Types of Bonds
The most common types of bonds include:
Government bonds – issued by governments around the world; these pay regular interest payments and have maturities ranging from one year up to 30 years. They tend to carry higher yields than private-sector issues because their issuers must meet certain financial standards set out in international treaties such as the Basel Accords. These accords require countries to maintain high levels of public spending and reserves against foreign currency liabilities. In addition, some governments issue specialized bonds which offer additional features such as tax benefits or insurance cover. For example, UK gilts provide protection against inflation while US treasury bills do not.
Corporate bonds – issued by companies, banks, and other organizations to raise funds. Their main advantage is that they often come with lower borrowing costs than bank loans. Companies use the proceeds to finance projects such as factories, office buildings, and equipment purchases. Banks borrow money using corporate bonds as collateral so that they can lend it out again. Other uses include funding mergers and acquisitions. Some corporations sell bonds directly to individuals through brokers.
Mortgage-backed securities – created by bundling together many different mortgages and selling them off as a single asset. Investors receive periodic repayments based on how much each individual borrower owes. Mortgage-backed securities were first introduced during the 1980s boom but became popular after the global credit crunch of 2008–2009. Many people now believe that they could become another source of systemic risk in the event of further economic downturns.
Bonds are traded actively throughout the day on stock exchanges around the globe. Investors can trade bonds online via specialist brokerages. Alternatively, retail customers can access trading platforms offered by large banks such as HSBC Holdings plc, Barclays PLC, Citigroup Inc., JP Morgan Chase & Co.
The price movements of bonds reflect changes in investor sentiment towards particular sectors and economies. If there is general optimism about the economy, demand increases, and prices go up. Conversely, pessimism leads to falling prices. Interest rate rises lead to falls in bond values since borrowers need less money to service existing debts. Rising oil prices cause concern among energy producers and consumers alike, leading to increased volatility in commodity markets. As well as affecting bond prices, rising fuel costs affect consumer confidence and spending power, which in turn affects business activity.
Benefits of Bonds
We have several benefits when we invest in bonds:
We get paid for our investment over time. This means that if you buy $1m worth of 10-year Treasury notes at 5% per annum, then your return will be $5m after ten years. You don't make any more until the maturity date. The longer the term, the greater this benefit becomes.
There is no minimum purchase amount. So even small investors like us can participate in the market.
It’s easy to understand what happens to an investment. When you buy shares in a company, you own part of its assets. But when you buy a bond, you simply loan money to the issuer. At the end of the period, you either get back the entire principal plus interest, or nothing.
Government bonds are considered safe investments. They pay regular income every year. In addition, their value tends not to fluctuate too wildly compared to stocks.
Unlike equities, where ownership rights change hands frequently, bonds remain fixed. That makes them easier to manage.
Risks of Bonds
There are risks associated with investing in bonds. These include:
High initial cost: Buying bonds involves paying upfront fees to financial institutions. For example, buying US Treasuries requires a fee of 0.25%. However, these charges tend to fall over time.
Duration mismatch: Most bonds mature within five to seven years. During that time, the yield may rise above inflation. Therefore, it pays to hold shorter duration bonds rather than long ones.
Market liquidity: Because bonds are relatively illiquid, it takes some effort to find buyers and sellers. Also, they cannot easily be sold short.
How do I Invest?
You should consider whether you want to invest directly in securities or through mutual funds. Directly invested securities offer higher returns but also carry riskier potential losses. Mutual fund managers seek out low-risk opportunities and spread the risk across many different types of security. Both options require research before making decisions.
You can choose from two main ways to invest in bonds – direct investment and indirect investment.
Indirect investment, you take physical possession of the underlying asset. Examples include owning stock certificates or holding cash.
Indirect investment refers to purchasing debt instruments such as corporate bonds, municipal bonds, treasury bills, etc. Here, you lend money to another party who owns the asset. Your lender receives periodic payments on the basis of the agreed terms.
When choosing between direct and indirect investment, remember that both methods involve borrowing money. If you have little experience managing finances, we recommend using a professional advisor.
A third option is to use mutual funds. A mutual fund pools together other people’s money and invests it in various securities. As a result, there is less need to borrow money. Instead, the manager buys securities based on his/her analysis of the current economic environment.
The advantage of mutual funds is that they provide diversification. This means your portfolio will contain more risky assets while still offering protection against market downturns.
The disadvantage is that most mutual funds charge high management costs. You must decide if this tradeoff is worth it for you.
Frequently asked questions
1) What is an index bond?
An index bond tracks the performance of a particular benchmark like the S&P 500 Index. It does so by tracking its components. The SPX consists of large companies listed on major exchanges around the world. Its constituents are weighted according to how much each company contributes to the overall weighting of the index.
2) How do I buy a bond?
To purchase a bond, you first deposit money at a bank or brokerage firm.
Then, you request a loan that represents ownership rights to the bond. Finally, you sell those rights back to the institution lending you the money. In return, you receive interest payments until the maturity date when you get paid off.
3) Why would someone pay me to own their bond instead of just selling them?
If you don't plan to keep the bond after it matures, then why not simply sell it? There's no reason to hold onto something that has lost value over time. However, if you intend to continue investing in the same type of instrument, buying shares may be preferable because it allows you to participate in future gains without having to wait for the entire transaction to complete.
4) Can I make money with my bond investments?
Yes! Bonds typically generate income. Income earned from bonds is tax-free. So long as you reinvest any dividends received into new bonds, you'll benefit from compounding returns.
5) Do all bonds perform similarly?
No. Some bonds offer higher yields than others. For example, Treasury Bills, Municipal Debt Securities, Corporate Bonds, Mortgage-Backed Security, Government Agency Notes, U.S. Savings Bonds, and Eurobonds.
Bond Investing can be very rewarding but requires patience and discipline. Be sure to read up on what makes different types of bonds tick before making your decision.