Bond Basics: What are Bonds?
Bonds have a reputation for being somewhat boring by virtue of the fact that they are
considered to be safe, stable, reliable investments with limited growth potential. For this reason, many amateur
investors ignore bonds altogether. However, this goes against one of our cardinal rules: Never get emotional about
trading. As with any other aspect of investment knowledge, ignoring bonds altogether is a mistake. While it's true
that in a bull market they can seem to offer insignificant returns compared to stocks, but all it takes is a bear
market for investors to again recognize the value of the stability provided by bonds.
What Are Bonds?
So what are bonds exactly? It's quite simple, actually; a bond is really nothing more than a loan, but instead
of you taking out the loan to buy a car or house or whatever, you are the lender. Companies and government
organizations require capital for everything, but large organizations require much more than can be provided
through regular channels such as banks. The solution is for them is to issue a bond on a public market, whereupon
hundreds or thousands (or even millions!) of investors will provide the needed capital.
How Can I Make Money From Bonds?
Obviously, you don't just lend money to large companies and government organizations out of the goodness of your
heart. When a bond is issued, three quantities are specified by the issuer. The face value of the bond is the
amount you are lending. Returns on a bond are specified by the interest rate of the bond, often referred to as the
'coupon', as well as the time you hold the bond; the date on which the bond issuer has to repay the loan is called
the maturity date. The nice thing about bonds is that you can always determine the exact amount you will get back.
As a quick example, let's say you buy a bond for a face value of $1000, a coupon of 5%, and a maturity of ten
years. This means you would receive $50 per year in interest payments for the next ten years, and then at the end
of 10 years you would receive the face value of $1000, providing a total return of $500 on your investment. Of
course, in such a scenario your real profit would not actually be $500 since we haven't accounted for inflation, so
be careful of that, but you get the idea.
Debt versus Equity
An important difference between stock and bond securities is that stocks are 'equity' whereas bonds are 'debt'.
When you buy equity in a company, you become a part owner in that corporation which comes with additional rights
such as voting and profit sharing. When you purchase bonds, on the other end, you become a creditor to that
organization. The advantage to this is that creditors take priority over shareholders in the case of bankruptcy.
The flipside is that if that company does phenomenally well, the bond holder will not share in the profits, he or
she will only be entitled to the face value plus the interest.
To summarize, bonds can be an excellent low-risk investment choice and for this reason you should definitely
consider bonds as part of your investment portfolio. It's unlikely however that you will get rich on just bonds
alone, so keep your other trading alternatives alive and use bonds primarily as long-term investments.