Monday, May 23, 2011

The Name Is Bond...

Okay, so it's not really about James Bond, but I couldn't help but resist the cheesy pun.  It was either a picture of this or Barry Bonds, or I could have gotten a very boring picture of a certificate which is the type I will be discussing in this post.

So if you haven't already read the first post on bonds, I would recommend going there first.  This post will just take a more in depth look at what bonds are, the different types of bonds out there, and why you should consider investing your money in them.

As I mentioned in my first post, bonds are thought of as "safe" securities.  It is a type of debt investment: you are giving your money out as a loan and expect to be paid back in full with some interest for your trouble.  Bonds are used by governments, states, companies, municipalities.  This is where most of the risk lies with bonds, and like I mentioned in the other post, the payment of your bond depends on the reputation of the bond issuer.  With corporate bonds, these can be quite risky (some of the riskiest bonds are called junk bonds, implying that you would essentially be buying junk since it isn't that likely that you would get paid, but these bonds often have the highest returns).  In technical terms, these bonds are given a low rating.  I will make another post about the ratings later on and what you should watch out for, so for now assume that the bonds we deal with are guaranteed and safe.

Bonds can also be split into Coupon Bonds and Discount Bonds.  A coupon bond is a bond that pays interest out during the waiting period, so if you buy a coupon bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years, you will receive semiannual interest payments of $40 ($1,000 * 8%/2) until the end of the term when you receive your $1,000 back.

 A discount bond is a bond that you purchase at a lower price than its face value (the value you would receive at the end of the term).  For example, if you buy a $1,000 face value bond for $950, then you pay out $950 now and get $1,000 when the bond matures (making you $50 over the time until maturity).

Generally, the yield (or percentage your money earns for you) on bonds is quite low.  Currently, the government bonds available give 2% back for a 5-year bond, 3.125% for a 10-year bond, and 4.375% for a 30-year bond.  One year and less has <0.20% return which makes it close to nothing.  With such low returns, you may ask yourself why you would bother investing in bonds.  While stocks are almost always better in terms of overall return in the long-run, you may want to look into bonds if you have some goals for the short-run.  If you are retiring (which shouldn't be for a long while), you would look more into bonds since you won't be working and obtaining a steady stream of income, so you would need your investments to provide a steady stream in the short-run.  Also, if you plan on making a large purchase within a few years (let's say you want to buy a car or you plan on going back to school to get your master's degree), bonds may be a better choice.

There are still a lot of factors to take into consideration when looking at bonds, but hopefully you have a basic understanding about how they work.  Next, we will take a look into the risk and ratings given to bonds.

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