Bonds Investing 101
All of us have borrowed money at some phase of our life. Be it a few dollars from our parents or borrowed money for college. Just like us, corporations and governments also borrow money from time to time. One way through which they borrow money is via banks but banks are always so hesitant to lend money. This is where the general public comes.
General public can lend money to corporations and governments. These debt investments are known as bonds. The government and private companies need money from time to time for a new project, for entering a new market or just to run their day-to day-expenses. Governments and private companies can raise extra finance through issuing bonds. Let’s understand this through some basic concepts. The issuer of the bond pays something extra to the individuals who have generously loaned them the money. This something extra is referred to as the coupon rate. Each year you will be paid interest payments until the bond expires, after which the principle amount will be returned. The date at which the bond expires is known as the maturity date. The amount borrowed is known as the face value of the bond.
Let’s reinforce this concept through an example. You buy a bond at the $1000 face value from Company ABC. It has a maturity date of 5 years and coupon rate is 5% annual. Thus, each year you will be paid $50 and at the end of the fifth year along with the interest payment, you will also receive the initial $1000 that you invested. So in the total of 5 years, you have earned a total of $250 more than what you loaned.
But now you may be wondering that I can earn extra cash by buying stock then why bother with bonds? Bonds are better than stock in the situation that if there is any event of liquidation, debt holders will paid the first. Preferred shareholders will be paid next and ordinary shareholders will be paid last. So the risk of losing your investment is less than in stocks. Also, buying stocks will provide you voting rights and you will be required to visit the Annual General Meeting. If you are a retired person or a student or if you are a person who travels a lot then this will not feasible for you. However, there is a possibility of default risk. This latter is when the borrower refuses to pay back the principle amount.
There are different types of bonds one may choose from. These are:
- Government bonds: These are sometimes knows as treasuries. Bonds that governments sell are safe as the default risk is close to none. So if you are a person that is not very risky, government bonds are for you. However, you will not be offered much coupon rate.
- Municipal bonds: They are also referred to as munis. These are bonds that are issued by local governments. The major advantage of munis is that the returns are free from federal tax. Additionally, local governments will sometimes make their bonds completely tax free.
- Corporate bonds: Companies can issue bonds just as they issue stock. The major benefit of corporate bonds is the higher yields. The coupon rate will be the highest in this type of bond but so will be the risk involved.
There are three ways through which you can buy bonds. These are as follows:
- Using a broker
- Purchasing through banks
- Purchasing from government’s website
This wraps up this tutorial. You now have a clear idea of what bonds are, how are they different from stocks, how many types are there and how to buy stocks.