For risk-averse investors, investing in bonds is preferable to investing in stocks. Purchasing stocks will give you partial ownership of a business. This ownership entitles you to a share of the company’s profits, but it also means that you have to shoulder its losses. Bonds are a less risky investment. They are less volatile, and the return is guaranteed. The reduced risk, however, means that the returns are not as impressive as those you’d get from stocks.
What are bonds and how much can you make from investing in them?
Bonds represent debt obligations. When an entity issues a bond, the money it receives in return is a loan. By purchasing this bond, you are essentially loaning money to the entity. Like with any other loan, the entity issuing the bond pays you back the initial capital as well as a fixed amount of interest for the period it takes the bond to mature.
Holding a bond to maturity guarantees you a return of your principal in addition to a steady flow of interest payments usually twice a year. This, however, is not the only way you can make money from bonds. You could sell your bond at a profit to another investor before its maturity. Keep in mind that the prices of bonds, move inversely to yield. This means that as the yield of a bond drops, its price rises due to the increasing investments in it and vice versa. By purchasing a bond below face value, you could later sell it when its price undoubtedly rises.
Bonds trade at par with their face value, at a discount or premium. Face value is the price at which the issuer of the bond will repurchase it upon maturity. If the bond is trading at an amount higher than its face value, its prevailing rates are lower than its yield meaning it’s trading at a premium. At a discount, the bond trades at a price lower than its face value. This means that its interest rate is lower than the market’s.
Four major types of bonds
Bonds can be classified into four major types depending on the issuer and interest rate yield.
High yield bonds: Also referred to as speculative or junk bonds, this offers the highest yield but come with the greatest risk. They pay a premium but getting your initial investment back upon maturity of the bond is not guaranteed.
Corporate bonds: Companies that do not want to borrow from banks or issue stock, issue bonds to raise funds for their own financing and investment needs. Such bonds are relatively risk-free, and they pay more than government bonds.
Municipal bonds: Municipalities issue these. Their yields are, but they are very safe and do not attract taxes.
Federal government bonds: These are the bonds with the least risk. This is the reason why they yield very low interests.
You have to evaluate a bond before investing in it. The three aspects that you should focus on are the interest rate yield, maturity date, and redemption terms. Depending on the issuer, these aspects vary. Before purchasing a bond, conduct proper research on platforms such as Investors Hangout to have a clear picture of what you’re getting yourself into.