Bonds are a type of investment that allows you to loan money to companies or governments in exchange for interest. When you buy a bond, you’re lending the issuer your money with the understanding that they’ll pay it back after a certain amount of time plus some extra cash on top as compensation for the use of your capital.
The company or government repays this borrowed sum at maturity, ranging from two years up to 30 years, depending on what’s negotiated when the issue is first launched.
6 Key questions about bonds
Here are the six critical questions about bonds and a detailed explanation to help you better understand bonds.
Who issues bonds?
Governments and corporations around the world borrow funds through debt issuance and use those funds to finance their operations and capital expenditures. Bonds may be issued by federal or municipal governments, state-owned enterprises and corporations. Both public and privately-owned companies may issue bonds.
How do I buy bonds?
The first thing you’ll need to do is open a brokerage account with an investment where you can trade either online or over the phone. To drive up your bond allocation, select “bonds” as one of the asset classes whose funds your new account will be invested in. That way, every time you make a deposit, some of it will automatically be allocated to bonds according to the percentage that’s been set by your broker (usually between 10% and 40%).
What are the risks associated with bonds?
Bonds come with a lot of fine print, so make sure you read all the documentation before buying any issues or funds (you can usually find them online). To avoid buying inferior securities, always invest at least 80% of your portfolio in high-quality bonds. Only hold between 10%-30% of your portfolio in lower grade or junk bonds, and don’t buy foreign-denominated debt unless you’re incredibly confident that exchange rates will improve shortly.
What happens if the issuer goes bankrupt?
If a company or government goes broke and defaults on its debt payments, your principal is essentially gone unless you own a bond fund. If a corporate bond loses 80% of its value or more, it’s typically considered an investment loss that can be written off as part of your capital gains for tax purposes. The same holds with mortgages that have been foreclosed upon. In both cases, however, you’re still responsible for any unpaid interest as well as penalties and late fees assessed by the borrower after foreclosure (if applicable).
What are the alternatives?
Many alternative investments can generate similar returns as long as you do your research first. Real estate, stocks, commodities and peer-to-peer lending are just a few examples of instruments that have historically outperformed bonds but have their own set of risks you should consider before making an investment commitment.
What are the average yields?
Since bonds aren’t traded very often, the yield quoted on a new issue is calculated by averaging the annual coupon rate over the life of the entire market for that particular security. In other words, even though you may end up paying more than its face value when you buy a US Treasury note from your broker at market price, there’s no guarantee that you’ll receive any additional payments beyond what other investors have earned in previous years a fixed income alternative.
Bonds work much like traditional markets ranging from commodities and currencies to major stock indices and individual stocks. Suppose you’re just getting started in fixed income or don’t have a lot of time to spend researching bond prices. In that case, your broker should be able to recommend the safest and most liquid securities based on your investment objective and risk tolerance. However, there’s no free lunch in investing when it comes down to it, so make sure you do some research before committing any capital. It is recommended that you contact a reputable online broker from Saxo Bank and try a demo account before investing your own money.