Looking for new ways to invest your money? Then consider the bond market. Though less exciting than the stock market, the bond market is more reliable and less risky. Unfortunately, many people don’t know much about bonds or how they work. Here’s a simple guide to lead you through the process of understanding and purchasing bonds.
What Are Bonds?
Unlike stocks, where you hold a share of a company, bonds are basically a loan you give to a company or the government. The reason companies issue bonds to the public is to raise capital they need to expand into new markets. Meanwhile, government bonds help raise money for things like programs and infrastructure.
So how do you make money off of bonds? Basically, the bond issuer has to pay you interest in order to get your money. When you purchase a bond, you get interest payments on a predetermined rate and schedule. The full amount has to be repaid by the issuer on the bond’s maturity date.
A major difference between stocks and bonds is that, if the company you hold a bond with enters bankruptcy, bond holders get paid back before a shareholder. On the flip side, you don’t get a share of the company’s profits if they’re doing well – you only get your fixed interest payment.
The Different Types Of Bonds
There are four main types of bonds:
- Government bonds: Bonds issued by the U.S. government are considered to be the safest and most reliable. Bonds from the government take more than 10 years to mature. However you can also get bills or notes, which mature faster.
- Municipal bonds: These are bonds issued by a city. They are only slightly less stable than government bonds. In some cases, municipal bonds are tax-free.
- Corporate bonds: These are bonds issued by companies. Corporate bonds tend to have higher yields, but also a higher risk level.
- Zero-Coupon Bonds: These are bonds that, instead of paying interest, are purchased at a lower rate than their full value.
The type of bond you purchase will be based on how much you want to earn in interest and how much you’re willing to risk. Bonds with maturity dates farther into the future usually have higher interest rates, but they are slightly riskier. With shorter-term bonds you may not earn as much, but you’re putting yourself at a lower risk for losing out on your investment.
How Bonds Work
If you plan to hold your bond until the maturity date, then it’s a fairly straightforward process. You loan the money, earn interest and then get the initial amount you paid back on the maturity date.
However, if you are considering selling bonds or buying bonds from a current bond holder, it gets a little trickier. The prices of bonds can go up and down over the course of the day based on the market. Meanwhile, the interest rates remain the same.
For example, your yield is higher if you purchase a bond at a discount rate (below the rate at which it was initially purchased for). If you buy it for more than what was initially paid, your yield is slightly lower.
You can also sell your bonds before the maturity date. When you do this, you’ll need to take into account how much you’d make if you held onto the bond until the maturity date versus how much you can sell it for now. For most people, selling a bond is a way to get money quickly when they can’t wait until the maturity date to get their money back.
How To Buy Bonds
There are two main ways to purchase bonds:
- Through a brokerage: Most bond purchases are done through a full-service or discount brokerage firm. These firms help you to find bonds that work for you and ensure that you receive your interest payments. Brokerage firms can also help you decide whether to buy a bond from a bond holder or sell your bonds before the maturity date.
- Online: You can also buy government bonds directly from the U.S. government online at Treasury Direct. This helps you bypass the time and expense of using a broker and you can even make payments electronically.
Brokers are great for first-time bond buyers and those who want to do lots of selling and trading of bonds. If you want something simple and straightforward and you want to wait until the maturity date to get your initial payment back, use the U.S. Government website to purchase bonds directly online.
Bonds can be tricky to manage if you are considering selling or buying them from a current bond holder. If this is what you are thinking about doing, get a broker who can help you navigate this process (especially if this is your first bond). Otherwise, enjoy finding bonds that work with your budget and sit back and relax until the maturity date.