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Getting to know bonds

Lesson in Course: Bonds (beginner, 3min)

Governments and companies can borrow money. How can we make it an investment opportunity?

Eureka!

What it's about: Buying a bond means we become a lender instead of a borrower.

Why it's important: We receive interest as income from our investment, with the riskier types providing us with higher rates.

Key takeaway: Investing in a variety of different types of bonds provides diversification.

While we might be familiar with borrowing money, we are on the other side of the transaction when we invest in bonds.

What is Bonds?

Debt, or loans, issued by governments and companies.

This means we are lending money rather than borrowing it. Like other forms of debt, bonds have a principal, interest rate, and maturity date. The interest payments for the money we loaned are called coupon payments.

What is Coupon payment?

The interest rate a bond promises to pay every year. It's a percentage of the face value (principal) paid from the issue date until maturity.

 

Government bonds

Governments borrow money by issuing bonds

Similar to how we borrow money to pay for expensive things such as a car or a house, governments will issue bonds to fund projects or significant expenses. Government bonds fall into two major categories: 

What is Treasury bond?

Debt issued by the federal government. They are considered one of the safest investments since governments in wealthy nations rarely ever default.

The federal government issues bonds to fund national infrastructure projects and other government spending needs as an alternative to raising money through taxes. We consider these bonds the safest and least risky because they are considered more financially secure and are less likely to default on their payments.

What is Municipal bond ?

Debt issued by local governments and investing in muni bonds comes with federal tax benefits. Muni bonds are considered fairly safe investments, but higher risk compared to treasury bonds since local governments can run into major deficits that make it hard for them to repay debt.

Local governments typically use muni bonds to fund public projects such as roads, schools, airports and seaports, and infrastructure-related repairs. These bonds usually have higher interest rates because local governments are slightly less financially secure and more likely to default. The higher interest rate is compensation for taking on the additional risk.

Corporate bonds

Businesses also borrow money by issuing bonds

Suppose a company has to raise additional cash to fund a significant project or pay for some extra expenses. They will typically finance it using debt by issuing bonds rather than selling equity by issuing stock. In general, corporate bonds are considered riskier than government bonds because companies have higher default risk and are more likely to go bankrupt. However, it ultimately depends on the creditworthiness of the company or the government issuing the bond.

We place these bonds into two major categories based on their creditworthiness.

What is Investment-grade bond?

Generally higher risk than government bonds but represent the most financially stable companies. These companies often have a proven operational history, stable businesses, and have consistently repaid all the debt borrowed.

What is High yield bond ?

Riskier corporate bonds and usually have the highest interest rates. While the interest rates are very attractive, the future of the businesses is usually uncertain, and companies may file for bankruptcy. In this case, we could receive only a portion, if any, of our money.

Actionable ideas

Bonds are generally less risky than stocks which makes them a great way of diversifying your portfolio. Since bond prices usually don't fluctuate as much as stocks, having a larger portion of your portfolio invested in them will help preserve your account value. Plus, you'll also be getting income from coupon payments.

Consider the type of bond that fits your investment goals and risk tolerance.

 

Supplementary materials

Check out this short video on bond basics
https://www.youtube.com/watch?v=IuyejHOGCro

Glossary

What is Coupon payment ?

A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value (value loaned) paid from the issue date until maturity.

What is Treasury bond?

Treasury bonds are debt issued by the federal government. They are considered one of the safest investments since governments in wealthy nations rarely ever default.

What is Municipal bond ?

Municipal bonds are debt issued by local governments and investing in muni bonds comes with federal tax benefits. Muni bonds are considered fairly safe investments, however, the risk is higher compared to treasury bonds since local governments can run into major deficits that make it hard for them to pay back debt. An example is the state of Illinois.

What is Investment-grade bond ?

Generally higher risk than government bonds but represent the most financially stable companies. These companies often have a proven operational history, stable businesses and have consistently paid back all the debt borrowed.

What is High yield bond ?

Riskier corporate bonds and usually have the highest interest rates. While the interest rates are very attractive, the future of the businesses is usually uncertain, and companies may file for bankruptcy. In this case, we could receive only a portion, if any, of our money.