Investing 101: What is a Bond?

Investing 101: What is a Bond?

It’s not difficult to find places to invest your money; nearly every bank, brokerage, credit union, and insurance company has a wide selection of investment products for you to choose from. The trick is to know which types of investments are right for you, based on your age, your comfort level with risk, and other factors.

Investors who want to avoid the risks of the stock market often turn to bonds. A bond is a type of investment where you effectively loan your money to someone, and they agree to pay you interest over the term of the bond. When the bond’s term ends, known as reaching its maturity date, you are paid back the full value of the bond. The bond’s interest is either paid out to you over the life of the bond, or it is included when the bond is redeemed.

When you buy a bond, you are like a bank lending money to a company—or even to the government, as you will see in this look at bond basics.

What types of bonds are there?

The two chief types of bonds are government bonds and corporate bonds. Let’s look at government bonds first.

Government bonds are issued by federal, state, and municipal governments. When you buy a government-issued bond, you are lending the government your money to be used in its annual budgets. In the case of a municipal bond, your money may be used to fund a specific infrastructure project, like a new stadium or a transit system.

Like most investments, government bonds typically pay higher interest rates the longer they are held. For example, a 30-year bond will offer a higher interest rate than a 10-year bond.

Government bonds are considered to be one of the safest investments available, as they are backed by the US Treasury.

What are US savings bonds?

US savings bonds are a popular government-backed investment. There are two types of US savings bonds: EE bonds and I bonds. EE bonds offer a fixed interest rate for however long the bond is held, from a minimum of one year to a maximum of 30 years. I bonds have a combined fixed and variable interest rate that’s adjusted for the country’s rate of inflation every six months.

Both EE bonds and I bonds can be bought in any increment of $25, up to a maximum of $10,000 in bonds purchased in a calendar year. You can also buy a savings bond as a gift for someone, although you will have to print out your own gift certificate; US savings bonds are no longer sold in paper format, only electronically.

US savings bonds are a popular government-backed investment. Click To Tweet

What are Treasury bonds?

Treasury bonds are another type of government-backed investment. Treasury bonds are sold in increments of $100, and come with a 30-year term. Treasury bonds are unique in that they are sold at auction, and the bond price and interest rate is determined during their auction. Your local bank or financial institution can tell you more about how Treasury bonds are valued and sold.

One key benefit of US savings bonds and Treasury bonds is the interest they earn is only taxed at the federal level, not at the state or municipal levels. What’s more, the interest made when a bond is redeemed may be totally tax exempt if the money is used to fund higher education.

What is a corporate bond?

Corporate bonds are issued by businesses much like they issue shares of stock. Corporate bonds come with a higher level of risk than government bonds, and so offer higher interest rates to compensate investors willing to take a chance on buying them. The lower the credit rating of the company, the higher the interest rate the company will usually offer on its bonds.

What are junk bonds?

You may have heard the term junk bonds before. Junks bonds are riskier investments because the company selling them doesn’t have a particularly good credit rating. This means there is a higher chance the bonds will be defaulted on. Junk bonds appeal to more daring investors who are willing to gamble on a company to maintain or grow its financial performance.

A junk bond can give a high return to investors, but it can also become worthless if the company fails. Two large junk bond events occurred in the financial crashes of 2001 and 2009, when many junk bonds were defaulted on, costing investors millions of dollars.

What is a bond fund?

A bond fund is like a mutual fund, except it is made up of a variety of bonds instead of a stock portfolio. The advantage of a bond fund is it offers investment diversity without having to buy a large number of different bonds from multiple sources yourself.

Investing in a bond fund allows you to choose the mix of risk and reward you’re comfortable with. A bond fund may offer more high yield corporate bonds than guaranteed government bonds, making it a higher risk but higher return investment. Or, you can choose a bond fund composed of mostly government bonds, with a few riskier corporate bonds thrown into the mix.

Bonds may be right for you

Bonds can be used to provide a stable source of investment income in difficult economic times. Government bonds and highly rated corporate bonds offer a low-risk method for putting your money to work. Bonds can also be used to create tax-exempt income for higher education. And, there are higher yield bond options available for investors who are more willing to take risks for higher financial rewards.

Have you ever considered buying a bond?

Aaron Axline

Marketing Writer at LawDepot
Aaron Axline is an author, technology journalist, blogger, and knowledge management expert based in Edmonton, Canada. He likes cats.

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2 thoughts on “Investing 101: What is a Bond?

  1. Aaron Axline Post author

    Hi there –

    The Canadian government just announced with its March 2017 budget it is ending the Canada Savings Bonds program. Apparently, sales of gov’t bonds have dropped to the point that the cost of maintaining the program didn’t make financial sense. Here is a link to the announcement.

    Corporate bonds are still available in Canada; however, many investors prefer to go with Guaranteed Income Certificates (GICs) as they are seen as being more secure and less volatile than corporate bonds.

    Great question! Thanks for taking the time to comment.

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