What is a Bond? And, why do I need to know about it? These are valid questions that deserve some consideration. A Bond is a type of investment, a debt instrument that, boiled down to its basic level, is an IOU. And, savvy investors realize the benefits of investing in Bonds.
Think back to your childhood. Did you ever receive a Savings Bond as a graduation or birthday gift? If not, do you remember your parents talking about buying US Government Savings Bonds? If so, you have a leg up on the rest. In this instance, you are investing your money with the Federal Government, and in return the Government will pay you interest on your money you “loaned” to them.
If, for example, you chose to purchase a $100 Savings Bond, you pay $50 now, to purchase the Bond, which means you’re buying the Bond at a discount. Then, over the next twenty years, the value of your Bond increases to it face value of $100, due to the accumulated interest. At the end of twenty years, the Bond would mature, and you go to the bank to collect your $100.
Another type of bond is a Corporate Bond. Again, keeping in mind the idea of an IOU, this would mean you are loaning a publically-traded corporation money, in exchange for that company paying you interest on your money. Corporate Bonds are less secure than the Federal Government, so in contrast to the US Savings Bonds, corporate bonds pay a better interest. This is not to say that Corporate Bonds are risky, per se. Interest rates on Corporate Bonds depend on a couple of factors: the length/term of the Bond and the rating of the Bond. Typically, the longer the term of the Bond, the higher the interest rate. And, the lower the quality of the Corporate Bond, the more interest will be paid.
When we speak of “Quality of the Bond,” we mean how the rating agencies rate the Bond. For instance, an A-rated Corporate Bond is better than a B-rated Corporate Bond. Corporations understand these ratings, and thus to incent investors to buy their Bonds they must pay a higher interest rate. The highest rating of a Bond is AAA. A very low rated bond would be CCC-rated. A Bond with a “D” rating would mean the Bond is in default, which means the corporation is in serious financial trouble, which means you will not likely get your money back. As a general rule, investors should think about buying Corporate Bonds with a rating of BBB or better.
A third type of Bond if a Municipal Bond. Sticking with our IOU-theme, this would be a debt instrument of a City, County, or State. Municipal Bonds, or “Muni’s,” for short, are considered safer than Corporate Bonds, because, similar to the Federal Government, Cities, Counties, and States have many “avenues” by which they can back their Bonds. We’re speaking of taxes. Cities and states have the authority to assesses many fees to generate revenue, such as city tax, gasoline tax, sales tax, parking meters, school fees, and more. Although it has happened, the likelihood of a City, County, or State going bankrupt is miniscule.
This is why Municipal Bonds pay a conservative interest rate. Granted, they pay more than Savings Bonds and more than Treasury Securities, but less than Corporate Bonds. Plus, Municipal Bonds have the distinction of being free from taxes at the Federal level. Many investors who are in the highest tax brackets, flock to Muni’s to save themselves taxes on the interest that the Bonds pay.
There are a few additional types of Bonds into which people invest their money, but let’s turn a corner and talk about why investors buy Bonds and the methods of buying them. One reason people buy Bonds is they are typically considered safer than stocks, and part of this reasoning has to do with the bankruptcy laws in our country. To keep it very brief and simple, there’s a pecking order for money instruments in our country, starting with the safest of the safe…the Federal Government. One basic reason for this, the Federal Government, in theory, cannot go bankrupt. They are the only entity that has Constitutional authority to print money. Follow this with Banks, then Municipal Bonds, then Corporate Bonds, and then stocks. So, investors looking for a better than bank-rate place to put their money, can look to Bonds.
To bring this article to a conclusion, let’s talk about the method of buying Bonds. How does the average investor buy Bonds? The answer is to seek out the advice and services of a Financial Advisor. A Financial Advisor can give you a variety of methods of buying Bonds. One way is to buy individual Bonds. For example, for Corporate Bonds, you could buy a Bond from Coca Cola, or Microsoft, or an oil company. For Muni bonds, you can invest in a local school Bond, a water or sewer Bond, or a City Bond. Be prepared to come up with at least $5000 for such a Bond, although occasionally a lesser amount can be found. One of the key benefits of purchasing several individual Bonds is when the interest is paid, you can create a steady stream of monthly income for yourself.
If you don’t have that kind of money to invest, another method is to buy a grouping of Bonds, through an investment called a Mutual Fund. In this type of arrangement, you may be investing your money into dozens or even a hundred different companies or municipalities.
So, finally, Bonds are a method of investing your money, whether to make it grow, or to generate a regular income, that can be part of your overall Financial Portfolio. By doing so, you will provide some balance, and perhaps safety, to your 401k and other investments that are exposed to the ups and downs of the stock markets.