Investing can help you build wealth, finance a college fund for your children or line 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. It's best to look at all aspects of bonds in order protect yourself and maximize your returns.
TL;DR (Too Long; Didn't Read)
Bond issuers are the ones who borrow the funds, while the bond holders are the ones who lend the money.
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 therefore 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 known as credit risk. It can rear its head when business goes south in a poor economy or because it has been mismanaged. Even some governments, which can tax, are not immune from defaulting.
You can avoid a poor choice and potential trap by checking the bond 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 for 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're not forking over the fruits of your investment to the government.
High interest rates are your friend when you seek more income, but those same interest rates stunt the growth of your bond’s value. Your bond is priced at the value today, or present value, of the payments you're 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're 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.
Christopher Raines enjoys sharing his knowledge of business, financial matters and the law. He earned his business administration and law degrees from the University of North Carolina at Chapel Hill. As a lawyer since August 1996, Raines has handled cases involving business, consumer and other areas of the law.