Most people have little if any understanding of bonds, and so they wind up investing in stocks and stock funds and pretty much anything else. But bonds are a major type of investment, so I created this handy-dandy guide to bonds to help you increase your investment IQ!
What exactly are bonds?
Imagine you lend your friend $1,000. Your friend agrees to pay you back in 10 years, with an extra 5% in interest each year until she is able to give you the original $1,000 after the ten years is up. That’s essentially the same way that a bond works.
I know bonds can seem scary and complicated, but they’re really quite straightforward. A bond is simply a loan you make to an issuer (corporation or government) so they can use your money. The issuer (borrower) then agrees to pay you back after a certain period of time with interest along the way.
How much time? It depends. You can have a 5 year, 10 year, or even a 30 year bond. The longer the time period, the higher the interest rate (with some exceptions), since you’re giving up your money for a longer time. Generally speaking, they make the payments on a fixed schedule, usually twice a year.
What’s the benefit of investing in bonds?
The main benefits of investing in bonds are safety and predictability. You probably know that the stock market can be pretty volatile, with large swings up and down. There can be years when you lose money, sometimes a significant amount.
When you own bonds, this is not a concern. The issuer of the bond makes regular payments to you on a fixed schedule. There is no need to worry about what’s going on in the stock market.
In addition, bonds are predictable. This is extremely helpful in budgeting and financial planning. You know exactly how much the issuer will pay you each year, so you can plan accordingly.