The Basics of Bonds

Bonds are vital components of many investment portfolios. Knowing about the different types of bonds, as well as their use in terms of investments, is very beneficial. This article will delineate the use of bonds, and their basic principles.

Bonds Vs. Stocks

When many people think about investing, they think of stocks, that is, shares of a company. However, bonds are also central to investments as well. While stocks purchase a share, or portion, of the issuing company, bonds are basically IOU's and loans. By obtaining a bond, you lend your money to the company or issuing organization, and they will pay you back, with a certain interest rate, after a certain length of time. Like stocks, bonds are often traded through brokerage firms.

Issuers of Bonds

Bonds issued by cities are called municipal bonds (or munis), which usually finance city operations and infrastructure. For example, a school district may issue bonds to finance school construction. Quasi-governmental organizations can also issue bonds. Corporations issue corporate bonds, which are more risky, but can pay higher interest rates.      

Why Bonds?

Bonds are win-win, for both the investor and the issuing organization. Bonds are issued by organizations that need cash for operations. Groups issuing bonds range from companies needing an influx of capital, to cities, states, and the federal government. In general, bonds are considered to be "safer" investments than stocks and more predictable, but with a lower rate of return. Stocks are more volatile, but can have large payoffs. Bonds, on the other hand, are more predictable, especially government bonds. The United States Federal Government, for instance, issues bonds that are backed up by the government's full faith and credit, used as an alternative to taxation to raise funds for governmental operations. Thus, barring a federal default, U.S. government bonds are therefore considered to be safer investments, for instance. 

How They Work

Bonds are issued having a certain "face value," which is the amount you will get back, when the bond matures. However, these bonds are then sold in the market, which can raise or lower their cost on the secondary market. If the bond in the market costs less than the face amount, then the bond is being sold at a discount. If it costs more, it is sold at a premium. Bonds also pay interest: this is fixed during the length of the bond, that is, the bond's maturity, while interest is paid, until the original investment is given back to the investor. Therefore, bonds can be called "fixed-income securities." A bond's yield is basically the return that you will make by holding the bond, through interest, etc.

Junk Bonds

Not all bonds are the same. In fact, bonds and their interest rates can vary by the issuer. If the issuer is considered to be more dependable, such as the U.S. Government, then interest rates are lower. For organizations perceived to be more volatile, interest rates are higher (to act as an incentive for investors to buy into the increased risk). Bonds are rated by organizations such as Moody's and S&P give bonds different ratings, to determine how credit worthy ("safe") they are. These are, in effect, the basics of bonds.