Governments and companies can borrow money. How can we make it an investment opportunity?
While we might be familiar with borrowing money, we are on the other side of the transaction when we invest in bonds.
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.
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:
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.
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.
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.
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.