What are bonds?
Governments and companies issue bonds in order to fund projects, maintain ongoing operations, or refinance existing debts for the company. They therefore borrow money from investors who, in return, earn interest on the money they’ve loaned.
Individual investors invest in bonds with the view of earning additional income from interest. So it’s a win-win for both the borrower and investor because the company will be able to fund their project — such as building a new office — and the investor will generate additional income through interest.
KEY TAKEAWAYS
- A bond is a loan given to a company or government institution by an individual investors
- Bonds are issues by companies and governments in order to raise capital to accelerate growth and fund projects
- The way of earning money through bonds is through annual interest
- It is considered a safer way to make money through investing as you are guaranteed an annual interest payment
- The returns are therefore slow, steady and safe
How do bonds differ from stocks?
Bonds are considered a less risky and more predictable investment compared to stocks. The reason for this is that the company promises to return the money in 10 years, awarding an annual interest rate to the investor as a thank you.
The company or government will therefore give back (for example) 5% of the £1,000 dollar loaned to them every year. That means the investor will get £50 straight into their account every year as an incentive. The investor will then redeem their bond at the end of the 10 year period, having received regular interest payments each year. They will eventually redeem the £1,000 principal investment, but over the 10 year period would have earned £500 in bonds.
The reason bonds are more predictable than stocks is because they’re not driven by market forces which are renowned for spiking up and dipping down (causing many of us to lie awake at night)!
How to buy bonds?
Bonds are not traded publicly in the stock market like stocks, meaning they need to be bought directly through a stockbroker. In the UK, for example, you can also purchase them through fund supermarkets or by going directly to the government's Debt Management Office.
Are bonds risky?
Government bonds are considered less risky than corporate bonds. Of course, we don’t know if a company is going to go bankrupt a few years down the line — and if it does, it would fail to give back the $1,000 you lent them. Those companies considered higher risk will generally offer higher interest rates: they might offer 5% instead of 2% in interest.
Credit rating agencies rank bonds, helping financial investors to assess whether a bond is worth their investment. It’s therefore worth checking the rankings of particular bonds before making your final decision.