bonds

WTF: Bonds For Beginners

Understanding bonds is key to grasping how financial markets work. Knowing a little about bonds can help a lot.

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A bond is a document in which a government or company promises to pay back money that it has borrowed, along with interest.

Essentially, bonds are sold as a type of loan, where the issuer (whether it be a government or corporation) takes an investor’s money with the promise of paying back the principal as well as a pre-determined rate of interest.

Also known as bills, notes, debt securities, or debt obligations, bonds are used by individual investors, corporations and and governments, and play a role just about any well-planned financial strategy.

Bonds are so popular that they account for $100 Trillion in global investment, much of which is fueled by government purchases to prop up economies in troubled times.

The payout of a bond over its lifetime is called the “yield”.

Different bonds have different yields. Here a few different types of bonds along with their respective yields:

  • CORPORATE – just like a company can issue stock, they can also issue bonds. Corporate bonds’ maturity rates vary anywhere from 5 years, to 12, or sometimes longer. Since corporate bonds are often riskier than government variations (since corporations have a much higher chance of defaulting), they typically yield a higher interest rate.
  • GOVERNMENT – these notes are backed by the government that issues them and encompass everything from savings bonds, to treasury bonds. They are considered extremely low risk but also carry lower interest rates.
  • MUNICIPAL – similar to government versions, municipal bonds are also backed by government, albeit city government. Since municipal notes are free of federal tax in the US, and sometimes even state tax (if you’re a resident of the city), they can be quite desirable to the right investor.

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Advantages and disadvantages

Bonds may not sound very exciting to many people, but savvy investors understand some of the compelling advantages – and risks- that they can provide.

Advantages

  • LOW VOLATILITY – bonds are typically considered to be much less volatile than other investment options like stocks. This often means that the risk associated with investing is much lower, especially when it comes to government or municipal bonds
  • BALANCING EFFECT – they can be extremely useful tools for helping balance one’s portfolio–specifically one that also deals in riskier methods like stocks (which are not unknown for dipping 10 percent in a single year)
  • BETTER THAN BANKING – the yields on notes are more often than not substantially higher than putting one’s money into a bank account

Disadvantages

  • UNRELIABLE ISSUER – values are largely dependent on the credit rating of the issuer. If an issuer’s credit rating were to suddenly drop, so too would the price of the note
  • FAULTY RATING SYSTEMS – though bonds, unlike stocks, are rated by agencies like Standard and Poors, such rating systems aren’t always accurate–as evidenced most clearly by the 2008 financial crisis when millions of junk bonds threatened to crash the market
  • TAXABLE BONDS – notes that are taxable, like corporate versions, must be reported on an investor’s income tax return. This can cut heavily into an investor’s profit

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Bonds signal global economic trends

In times of economic turmoil or uncertainty, investors flock to government bonds because of their safely.  In essence, fearful investors park their money in government bonds knowing that their money is safer than in other investments, despite possibly earning low yields.

For instance, in 2016 as uncertainty about global economic conditions took hold, the yield for a German 10-year sovereign bond turned negative for the first time in history.  In other words, investors are not making any money on the bonds, but paid out money instead.

Once unheard of and impossible to imagine, in 2016 negative yields for government bonds were also in effect for bonds from Japan’s government, as well as those from some other European countries.

Negative bond yields, just like negative interest rates from central banks, are an ominous economic sign.

The takeaway

So how do you know if investing in bonds is right for you? It depends on your appetite for yields and risk.  The smart thing to do is to develop a financial plan and invest wisely according to a long-term strategy.

That said, if you’re an investor like the one described below, you may want to consider delving into the bond market:

  • LOOKING FOR STEADY INCOME – they usually provide a steady stream of income that may be ideal for investors looking to live off of their investments
  • LOOKING FOR LOWER RISK – they can help de-risk a portfolio that’s heavily focused on other riskier investments. In times of economic uncertainty, government bonds can be used to preserve cash, even if one has to pay for the prividge when yields go negative
  • LOOKING FOR LOWER TAXES – untaxed versions like municipal bonds can provide investors an avenue for lower taxes

Cover photo by The Karen D via Flickr

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James Pero