Investing can be a solid way to earn income, and bonds are one of the most popular investment vehicles to accomplish this goal. While stocks pay dividends, bonds pay interest to the investor. Understanding the difference can help you determine how best to invest your money.
Bonds vs. Stocks
While both governments and corporations issue bonds, only corporations sell stocks. When stocks are purchased, the investor is buying ownership in the company and you become a shareholder. When bonds are bought, the investor is loaning money to the issuer of that debt. Those issuers include corporations, the federal government, foreign governments and state and local governments. Bond proceeds are used to fund capital projects or cover operating expenses.
Dividends vs. Interest
Company stocks are offered at the time of a company’s initial public offering. The earnings and profits of the company are used to pay dividends to shareholders. Because bondholders are simply loaning money, they do not have ownership in the company. Therefore, they do not have an ownership stake and cannot receive dividends. Bondholders, do, however, receive interest payments because of their loan.
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Before deciding to sell bonds, the issuer will determine the best way to structure the deal so that they pay the least amount of interest as possible. Bond buyers should understand that the price they pay for the bonds are based on interest rates. When interest rates rise, bond prices fall; and when interest rates fall, bond prices will rise.
There are many factors that determine how much interest a bond investment will pay. One is the credit quality of the issuer. Issuers whose credit is barely rated as investment grade are seen as having an increased risk of defaulting. To make their bonds attractive, they have to pay more in interest. Issuers that have strong credit are seen as being less likely to default, so they pay less in interest. The length of time the bonds are outstanding before they mature also determines the interest rate paid to the bondholders. Bonds maturities can range from a day to more than 30 years. The longer they are outstanding, the more likely they will be subject to interest rate fluctuations. Interest is generally paid semiannually.
Bond Investment Benefits
A benefit of investing in bonds is that the interest paid by the issuer is federally tax deductible. Fixed-rate bonds can be a reliable source for investors who want to avoid the ups and downs of the stock market because the principal and interest payments are made on a regular and predictable schedule.
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