What Are Bonds?
A bond is a type of debt issued by a corporation, government or other organization where the purchaser pays a certain amount to purchase the bond and, in exchange, will receive either a lump sum after a certain period of time or specified recurring payments over a period of time. For example, you might pay $50 to buy a bond that will pay you $75 in 10 years or will pay you $10 per year for the next seven years.
Types of Bonds
Bonds come in a range of types. U.S. Savings Bonds are some of the most well-known bonds, which are issued by the federal government and pay interest until you cash them in. Until you cash them out, you won't pay any taxes on the accumulated interest. State and local governments issue their own bonds. Corporations also issue bonds to fund their own needs for cash. According to the U.S. Securities and Exchange Commission, the corporate bonds are generally divided into two categories: investment grade bonds, which are safer but have lower interest rates, and high-yield bonds, which have higher interest rates but are issued by companies that have lower credit ratings.
Why Entities Issue Bonds
Bonds provide a cash infusion to the issuing entity that can then be paid back over time. For example, a county wanting to build a new school may issue bonds to finance the construction and then pay the cost over time. Alternatively, a corporation could issue bonds to pay for an expansion project into a new market. In addition, corporations may choose to issue bonds so that they don't give up any ownership of the company. If a company issued stock, the people who purchase the shares own a portion of the company. With a bond, the purchasers are only creditors of the company.
Benefits of Investing in Bonds
Bonds claim to provide a specified rate of return over the life of the bond, which allows bondholders to anticipate how much money they will make and how steady their stream of income will be. For example, if you buy a bond that makes interest payments of $100 per year for 10 years, you can expect to receive $100 per year. If you were to take that same money and invest in the stock market, you might earn $100 one year, lose $150 the next year and then bring in $250 the following year.
Risks of Investing in Bonds
Investing in bonds isn't without risk, however. First, there's always the chance that the bond issuer simply won't be able to pay back the money. For example, if you buy a bond from a company that goes bankrupt, you're out of luck. Second, interest rates or inflation rates could rise, leaving you stuck with a lower rate on your bond. For example, if a bond promises to pay 6 percent interest for 10 years and the market rate jumps to 9 percent a year later, you're still stuck receiving just 6 percent for the duration of the bond. Finally, if your bond isn't going to be paid off for a long time, you may have a hard time finding someone to buy it from you if you need cash in a hurry.