Introduction to Bonds

What are Bonds

The beginner investor will probably have heard of bonds and the financial press frequently mentions them, but just exactly what are bonds.

A bond is nothing more than a loan, which means that the bond investor actually leads money to either a government agency or to a company for which in return the bond investor receives an interest payment.

The beginner investor may well be wondering why these government agencies and companies would want to borrow money from investors.

Why don’t they just borrow the required money from a bank? Of course the bank is the first place anyone goes to; however banks tend to be quite conservative with gearing, which means they don’t like to loan too much money to any one agency or company in order to manage their risk.

These government agencies and companies must therefore seek alternative sources to fulfill their funding requirements and the next cheapest source is to borrow money directly from investors.

The money raised by issuing bonds is used for a variety of purposes.

Bonds are often held in investing portfolios – usually as a means of smoothing out the returns, but this also tends to lower the returns over the long-term.

Bonds can be bought and sold through a bond broker. Some stock brokers also provide a bond brokerage service.

Common Government Issued Bonds

The common government issued bonds are U.S. treasury bonds and municipal bonds.

The U.S. federal government primarily issues Treasury bonds to finance its debt. They are considered to be the safest bonds and are issued with various maturities (the number of months or years until the loan is repaid).

  • Treasury Bills: These are short term bonds with maturities of up to 52 weeks.
  • Treasury Notes: These are longer-term bonds with maturities of two to ten years.
  • Treasury Bonds: These are very long-term that typically mature in 30 years.

Treasury Inflation Protected Securities (TIPS) are notes and bonds where the original capital loaned is adjusted for inflation, which means that the amount paid at maturity is more than the original amount loaned (assuming inflation continued to increase during the loan term).

Other Types of Bonds

Municipal bonds are issued by states, cities, counties and other government agencies in order to finance their capital investments in schools, highways, hospitals and other projects.

Bonds issued by companies are referred to as corporate bonds and can be issued by public companies (listed on a stock exchange) or issued by private companies.

The capital raised from issuing bonds can be used to finance working capital, finance expansion or acquisitions.

Bonds typically pay interest twice a year and provide investors with a predictable income source.

Treasury bonds are the safest bonds with regards to both the reliability of interest payments and the repayment of the loan at the bonds maturity.

Corporate bonds generally pay higher interest rates than government bonds, but are considered less reliable.

Basically, the higher the interest paid, then the higher the probability that the interest may not be paid or that the loan would even be repaid at maturity.