If you want an investment that earns money but generally carries less risk than investing in the stock market, the bond market might be perfect for you. A bond is a debt issued by a company or a government. They essentially use bonds to borrow money and pay interest until the bond matures. At maturity, the full amount of the bond is paid back.
You can also buy and sell bonds before they reach maturity. Here’s what you need to know.
Understand the Terminology
Bonds come with a lot of lingo you need to understand. For instance, the bond’s issuer is the company that borrows the money. The bond is issued for a predetermined amount of time, known as maturity, and the bond’s par value is the face value of the bond, generally $1,000.
The interest you’re paid periodically is called the coupon. This is the amount you earn in exchange for letting the company or government use your money. Once you know the issuer, the coupon and the maturity, you have the information you need to find the fair price of the bond.
Why Buy Corporate Bonds?
Corporate bonds sometimes offer a better interest rate than a simple savings account, but they are most useful for the coupon, which can provide consistent income each month. The best interest bonds are usually corporate bonds, which have better rates than government bonds.
Bond rates vary significantly, depending on the risk of the company issuing it. Well-established companies that issue bonds have one rate, while unstable companies have a much higher coupon. The higher interest rate compensates you for greater risk that the company could go out of business before repaying you. You can research corporate bond prices online.
Government bonds are considered very stable and low risk, so they don’t offer a very high coupon. As with corporate bonds, there are short-term and long-term options. One of the benefits of some government bonds is that the interest payments aren’t subject to state taxes. Municipal bonds and treasury bonds are examples. However, you have to pay federal taxes on the income. You can look up municipal bond rates by state.
The Risks of Bonds
Two types of risk exist for any bond. One is the default risk, the chance the company or entity that borrowed the money goes under before paying it back. The other is interest rate risk, the chance that overall interest rates rise significantly and make the coupon worthless. When interest rates go up, new bonds have better rates. The price you could sell the previous bond at would go down, making it less valuable.
Additionally, other types of safe investments could pay higher interest than the bond. It’s a challenging spot to be in, which is why many people choose to invest in short-term bonds to avoid it. Of course, short-term bond rates are lower because the risk is lower.
How to Buy Bonds
You can buy bonds directly from the issuer, but that’s only a good idea if you have significant capital to invest unless you’re buying treasuries. In addition, it takes a lot of research to make sure you’re getting a good price. Your broker may tell you the purchase is “commission free,” but that’s only because the company is charging you a markup.
Buying into bond funds can be a better alternative as long as the fees are low. Most bond returns are low to modest due to low risk, so you don’t want a lot of fees stealing your profits. You can also sign up for electronic bond trading sites to buy bonds online, but you want to proceed carefully. A lot of bond information isn’t publicized, and it can be easy to overpay. Consider using a reputable current bond price calculator.
Bonds can be a great way to diversify your portfolio or establish a steady income. However, you need to do some research to get the best deals.