Bonds, and How They Work
Bonds are a financial tool in which you agree to give a sum of money to another person, and they agree to pay you back that original sum of cash (called a "face value") at a later date, while also paying you smaller payments along the way. Basically, you are giving someone a loan.
These smaller payments, also known as “interest”, are typically a percentage of the money you originally gave them. So $1000 bond paying 1% interest would pay you $10 at each period of time the debtor has to pay.
The idea is that the total of all these payments will be worth the time that the original money-holder gave up, since money today is worth more than money tomorrow.
However, not everyone pays all their debts, the possibility that an entity will not pay you back due to fraud or mismanagement is the inherent risk of bonds.
Know that it may also be possible to sell or trade your ownership of a bond, as other entities may view the possibility of this non-payment risk differently, or that interest rates may change, or for a slew of other reasons.
Why Would Someone Want a Bond?
Bonds tend to have a certainty about them in that you can easily calculate how much money you are supposed to receive so long as you hold a bond to its maturity (when you would receive your original sum back).
While technically the value of a bond can change just like a stock, you can still get a “guaranteed” sum of money for as long as the entity can still pay out the money it owes.
Due to this extra certainty and the interest payments available with bonds, many people like to use them as a source of stable income.
What Types of Bonds Are There?
As time has gone on, there are now many different types of bonds with different features, functions, and other qualities to them. What follows is a list of major types of bonds you may encounter, but know there are probably more out there or even variations within these listed types.
Treasury Bonds
Bonds of the Treasury of a country tend to be considered the “safest” type of bond, given that if an entire nation cannot pay its debts, the financial situation of that nation must be in a dire situation if it even continues to be a nation at all.
Thankfully such extreme circumstances and events are rare in the modern world, but it is worth noting that even the safest investments in the world carry some element of risk.
Given the high perception of safety and certainty of payment for treasury bonds, they tend to carry the lowest interest rates.
Currently, the “safest” treasury bond in the world is the United States’ treasury bonds.
Government Bonds
These are noted separately from Treasury bonds, this represents any sort of debt that the government owes which is not related to the “core” health and finances of the country.
Governments may not have to pay these bonds if they are unable to, but usually it reflects terribly on the country if they don’t, so most bonds of governments tend to be viewed as safe, just not as much as their treasury equivalents.
Foreign Bonds
While I implied this in my previous two listings, government and treasury bonds do not have to come from the United States of America. You can also purchase bonds from other countries around the world! However, the implications of risk can drastically change from country to country depending on their current situations and economies.
In addition, there is also the issue of currency exchange rates which can affect the value of your bonds even if you simply wait to maturity.
Municipal Bonds
These bonds represent the debts of local of state governments, again being related to the “health” of an area’s government they tend to be considered safe.
Although the extra incentive of Muni-Bonds are that the interest they pay is often exempt from taxes. However the details on who can receive a tax exemption can depend on a number of factors and laws.
The tax exemption makes these a popular investment for high income earners.
Corporate Bonds
Rather than loaning your money to a government, it is also possible to get a bond from a company or business. They operate similarly, with the financial health of the company being measured for how “safe” it is to get a bond from them.
Those that are considered safe and are known for paying their debts often hold a smaller interest rate than those that are considered risky. These risky companies and investments tend to be called “High-Yield” bonds given that they often promise large amounts of interest payments to make up for their risky nature.
Mortgage-Backed Bonds
This type of bond is usually sold by banks, and is paid out with the mortgage payments from home-owners.
The unique risk about this bond is that of pre-payment, where home owners can possibly pay off their mortgage thanks to a sudden influx of income in their own lives. This possibility can make it where you do not receive as much money or value as you originally intended.
Zero Coupon (Interest) Bond
This quirky bond is often sold at a far lower price than what it would pay out when it matures, however this is because it does not give any interest for while you hold it. In a way, you can think of the interest as already being "priced in" as a discount off of the final payment you receive on the bond.
Convertible Bond
One can think of this as "Schrödinger's Bond", the unique feature of convertibles is that you can hold it to maturity and it will pay out like a normal bond. Or, you can choose to "convert" the bond into some value or number of shares of that company's stock (a concept we cover, here).
The idea behind this investment tool is that you can switch over to the stock of the company if it would ever seem like the better option, and would overall be more worthwhile to have the stock than to hold the bond of that same company.
More bond types will be added to this list as they become relevant.
If bonds sound interesting to you, or you have any more questions, give me a call at 203-956-0289. You can also send me an e-mail to wward@1stallied.com. Hope to hear from you soon!
