Investing can build help to your wealth, a college fund for your children and your retirement nest egg. A bond is an investment that works like a loan. You, as a bond holder, in effect become a bank, loaning money to generate interest income. When the bond reaches its end, or maturity, you get your investment back. Bond issuers -- the borrowers -- include businesses, school boards, municipalities and Uncle Sam. Bonds possess advantages over other types of investments, but there are possible pitfalls. You can research information about those who offer bonds to protect yourself and maximize your returns.
You can appreciate the benefits of bonds by comparing them with stocks, which make you a part-owner of a company and potentially partaker in its profits. However, stock investing has significant trade-offs. Because bonds are loans, the issuers have a legal obligation to pay interest and repay what they borrowed; they are indebted to their bond investors. A company owes no income to stockholders unless it declares dividends, which is not required. If the company liquidates, or sells off its property, bond holders get their money before stockholders.
Credit and Prepayment Risk
Bonds are not guaranteed to produce income. Although issuers make an obligation to pay you, it does not mean they will or can; this is called the credit risk. It can rear its head when business goes south in a poor economy or because it has been poorly run. Even some governments, which can tax, are not immune from defaulting. You can catch a potential trap by checking the issuer's credit rating from agencies such as Moody's or Standard & Poor’s. In addition, the bond issuer could pay the loan back before the maturity date. Prepayment is good for the issuer, but not you because you lose the interest and, thus, the money stream.
You generally owe taxes on the interest you receive from bonds. However, for interest on bonds issued by state or local governments, you avoid federal income taxes. Interest on Treasury bonds, which come from Uncle Sam, are exempt from state and local income taxes, but not federal taxes. Tax-exempt bonds normally pay lower interest rates; however, some tax-exempt bonds can bring more purchasing power than taxable ones because you are not forking over the fruits of your investment to the government.
High interest rates are your friend when you seek more income, but stunt the growth of your bond’s value. Your bond is priced at the value today, or present value, of the payments you are promised in the future; the bond’s face value, or what you loan, is discounted by the interest rate because you don’t get the payments today. If rates rise, you are likely to hold on to your bond; otherwise, you lose the interest and you would lose money from selling. When rates migrate south, you can unload your bond and get a windfall; however, if you reinvest, you’ll pay more and get less interest.
- San Jose State University: College of Business: Chapter 7: Bond Valuation
- The Ohio State University: Extension: Fact Sheet: Investing in Bonds: MM-0005-01
- U.S. Securities and Exchange Commission: Bond Funds and Income Funds
- Public Bonds: Municipal Bonds and Defaults
- Internal Revenue Service: Tax Topics: Topic 403 - Interest Received
- The American Association of Individual Investors: AAII Journal; How Interest Rate Changes Affect the Price of Bonds
- University of Michigan: Economics 102: Bond Prices and Interest Rates; Alan Deardorff
- Moody's: Look Up a Rating
- Standard & Poor's Ratings Services: Browse Ratings by Practice
- New York State: New York Bonds: Certain Basics of Municipal Bonds
- University of Colorado: Principles of Macroeconomics: Unit 8: Financial Markets and the Business Cycles
- Thinkstock/Comstock/Getty Images
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