What Is an Investment Bond?
A bond is an investment vehicle. Unlike stocks, when you buy a bond, you are not gaining any ownership rights to the issuing entity. Rather, the purchase of a bond is more like giving a loan to the entity. Bonds are an integral type of investment for many investors. They can provide steady and consistent income streams. Also, they are typically safer investments compared to stocks.
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Definition
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Again, when you buy a bond, you effectively make a loan to the issuing entity. Depending on the type of bond you purchase, you will either receive periodic interest payments throughout the duration of the bond's life, or you will receive an amount greater than the purchase price when the bond matures. The bond is considered debt to the issuer of the bond.
When a bond is issued, there is a defined time limit to the life of the bond. This is called the time to maturity. Bonds are issued with many different times to maturity. Some bonds mature in a month, while others mature in 30 years.
Who Issues Bonds?
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Many different types of entities issue bonds. The United States government is one of the largest issuers of bonds, and U.S. Treasury bonds are considered the safest investment since they have the full backing of the United States government. Municipalities, such as cities and towns, also issue bonds. They use the proceeds from bonds for infrastructure and maintenance projects. Finally, corporations sell bonds to fund expansions and day-to-day operations.
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Types of Bonds
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There are two main types of bonds. First, coupon bonds pay periodic interest, or a coupon. The coupon payment is typically paid monthly or quarterly. When you purchase a new issue bond, you pay the full face value of the bond and receive the coupon payments throughout the life of the bond. At maturity, the issuing entity will pay back the face value of the bond.
The second type of bonds is zero coupon bonds. As the name suggests, zero coupon bonds do not disperse periodic payments. Instead, the bond is initially sold at a discount to the face value of the bond. For example, you may buy a zero coupon bond with a face value of $1,000 for $600. After holding the bond to maturity, you will receive $1,000 from the issuing entity.
Benefits of Bonds
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Compared to stocks, bonds are typically a safer and more predictable investment. If you buy a new coupon bond offering, you know what monthly or quarterly coupon payment you will receive. This allows you to plan your budget with the knowledge that you will be receiving a steady income stream from your bonds.
If a company or municipality declares bankruptcy, bondholders are in a better situation than stockholders. Bankruptcy law dictates that a bankrupt entity must pay back bondholders before stockholders. Finally, if you hold a bond until maturity, you do not have to worry about fluctuations of the bond price since coupon payments and the face value of the bond do not change in most circumstances.
Warning
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Although bonds are considered by most experts to be safer investments than stocks, bonds are not without risk. If the issuing entity declares bankruptcy, there is the distinct possibility that you will lose all or a part of your investment. Also, the prices of bonds fluctuate. If you hold the bond to maturity, you do not need to worry about the price fluctuations since you will receive the full value of the bond. But if you need to sell the bond before maturity, there is the possibility that the price at which you can sell the bond is below the price that you paid for it. Before making any investment decisions, including buying bonds, be sure to do your own research or speak with your financial adviser.
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