How Do Bonds Work?

How Do Bonds Work?
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Bonds work like a loan, only when you buy a bond, you’re the lender. You hand money over to an organization, which then issues interest payments to you based on the terms stipulated in the bond. Each bond has an expiration date, at which point it “matures” and the organization pays you the amount you originally gave for the bond, also known as the principal.

What Are Bonds?

When an organization issues a bond, it essentially takes out a loan for the amount on the face of the bond. The highest yields will likely come from business bonds, which are issued in the form of investment-grade corporate bonds from companies that have strong balance sheets. Businesses that are on the weaker end with their balance sheets issue high-yield bonds.

Many Americans are most familiar with government-issued bonds, however. The federal government issues treasury bonds to help with budget deficits. These are less likely to bring a high payoff, but if the economy tanks, you’ll see better returns from these than your corporate bonds. Government agencies like Fannie Mae and Ginnie Mae also issue bonds to support their own operations.

How Do Bonds Work?

Depending on the type of bond you’re interested in, you can get them through a variety of sources. A broker can match you with the perfect bond to meet your needs, or you can buy them through a financial institution. Corporate bonds are often issued directly to a specific group of investors, so you’ll need a special connection for one of those.

Treasury bonds are far less elusive than corporate bonds. You can buy them through a bank, broker or dealer, or you can create an account on TreasuryDirect and bid on them there. In addition to federal bonds, you can buy municipal bonds from local brokerages or banks.

How Bonds Are Paid

Once you’ve purchased a bond, it comes with a maturity date, which is the date you’ll get your initial investment back. Until that date, though, you’ll earn interest on a regular basis. Some bonds pay interest semiannually, while others only pay once a year.

How you are paid depends on how you purchased the bond. If you went through a broker, the bond’s issuer will send all of your interest payments to that broker, who will then forward them to you. If you purchased them directly through the issuer, that issuer will send them directly to you, often in check form through the mail.

Can You Lose Money in a Bond Fund?

Although some believe bonds are safe investments, they do come with a certain element of risk. The biggest risk comes from selling the bond before it reaches maturity. If interest rates have risen since your bond was purchased, you’ll notice a drop in value in the bond, making it a bad idea to sell. If you hold it until maturity, you at least have the hope of interest rates dropping.

But holding the bond to maturity also comes with a risk. Over the course of your time holding the bond, newer bonds may come on the market that you’ll miss out on by waiting. Since interest rates can be unpredictable, there’s no guarantee you’ll recoup your principal when you sell the bond at maturity.

How Do You Make Money in Bonds?

Bondholders make money from the interest the issuer pays over the course of the loan. That interest is called a coupon rate, which is based on what yield the bond paid when it was issued. The value of the bond changes with the market, though, which is why those interest payments can be so unpredictable.

Savvy investors learn to predict how a bond will perform over its life. It’s this same intuitiveness that has investors making so much money by choosing the right stock. A skilled broker can help you choose one bond that might do better versus another, but you can’t always rely on this advice.

Are Bonds a Good Investment Right Now?

The bond market has been in a slump for more than a year, but some see this as a good time to buy. However, experts are saying the slump is likely to continue, making this a bad time to put your money into bonds.

The best way to determine whether bonds are a good investment is to watch interest rates. As they rise, the value of your bond will drop, so it’s important to pay attention to what experts are predicting in this area.

Are bonds the right investment for you? Only you know the answer to that. But if you do choose to move into this type of investment vehicle, pay close attention to the outlook, since you can lose money if your timing isn’t right. If you have a trusty financial adviser on speed dial, pick up the phone and ask if bonds are a good investment once you’re ready to buy, since money experts pay close attention to the markets on a day-to-day basis.