What Are Bonds?

W hat are bonds? You’d think a simple question like that would have a simple answer. But when you first read about bonds, it seems like an impossibly complicated topic, and searching it up doesn’t help either since that just throws unfamiliar jargon at you, leaving you even more confused than before. 

Well to start, a bond is a form of investment in which an individual lends a company or government an amount of money, which the organization may use for buying equipment or other things they need, for a specific amount of time. During that time the investor will be getting regular interest payments and when the time finishes, the organization will give back the money lent.

Bonds provide a company with steady funding and they are able to acquire capital faster than if they were to work and save. As they say, you have to spend money to make money. Issuing bonds is a much safer option as an investor since, even if stocks plummet, you will still get all your money back. 

How many types of bonds are there?

Types of bonds are classified based on the entities they are issued from such as businesses, municipalities, and the government. Having said that, let us have a look at how these three types of bonds differ from each other.

Governmen­t Bonds: 

The government issues bonds from its treasury and from several government agencies to generate funds for programs, generate their payrolls, or pay bills. If the bonds are issued from a stable government like the United States, it can be an extremely safe investment. However, if these bonds are issued from a government of a developing country, the investment can be risky. 

Government bonds are further classified depending on the time they take to mature. For instance, T-bills are bonds that mature in less than a year, whereas, T-notes bonds may mature anywhere between one to ten years. On the other hand, Treasury bonds may take even longer than 10 years to mature.

Municipal Bonds: 

Municipalities issue bonds when the money collected through tax is not enough to fund projects such as the construction of hospitals, schools, power plants, bridges, airports, parks, universities, etc.

If you plan on investing in a municipal bond you do not have to pay federal income taxes on the interest earned.

Corporate Bonds:

Corporate bonds are issued by businesses to help fulfill their expenses. These bonds are riskier to invest in as compared to government and municipal bonds because you as an investor would have to study cash flow, debt, and how solid the company’s prospects and business plans are before pouring in your money. Obviously, a company with poor prospects would have a low-yield bond. Moreover, unlike municipal bonds, you do have to pay the federal income tax on the interest earned from corporate bonds.

How Bonds Work

There is a borrower and a borrowing organization when it comes to bonds. Both the lending party and borrowing organizations set up an agreed-upon date to pay the bond back. Till then, the borrower will make interest payments to the bondholder. These interest payments are also agreed upon by both parties beforehand. In simple words, if you own a bond you are a creditor or debtholder.  

Today, paper bonds are redeemed electronically, unlike in older times when people redeemed bonds by clipping coupons.

When the bond matures, the borrowing organization will repay the principal. However, most bondholders opt to resell them before they mature as there is a separate market for selling bonds. Since it can be resold, either publicly traded or privately, the value of the bond tends to fluctuate until it matures.

How To Do It Properly 

As fun and easy as it sounds to invest and make money, in most instances we just don't have enough time or skill to be able to research and be able to understand how it works and who to work with. To jump into it with no knowledge can be dangerous as you will be taken advantage of since you won’t be able to analyze the situation correctly. Fortunately, there are companies that will research a company's financial situation and decide on a bond rating that will benefit you most. Each company has its own methods to measure risk but you should also be mindful of what company you are trusting your finances with. Some may try to convince you to buy junk bonds which are low-rated high-risk bonds. So if you’re planning on issuing bonds, you should know the basics and know who to work with.