What is a bond?
A bond is a financial instrument that represents a loan from an investor to a borrower, which may be a company, state, local municipality, or sovereign government.
The duration of the bond might entail a higher payback by the issuer since it has the rate of interest upon it. Once the bond reaches its “maturity,” the investors or so-called bondholders enjoy interest income on the bond’s principal.
As of May 2022, it was estimated that global bond markets were worth $11.99 billion in their fifth weekly net selling in a row. Data also showed an outflow of $5.58 billion and $6.24 billion in US and European bonds, while the net profit margin peaked at $0.03 billion in Asian funds.
How does a bond work?
Also considered fixed-income securities, bonds are issued by a company with the purpose of keeping its operations and funding research and development, equipment, or different moneymaking projects.
Similarly, the government issues bonds for funding and to add revenue from its taxes. Various projects in infrastructures or other civil expenses may be funded by bonds.
Bond prices depend on the supply and demand in the market. Bonds mostly start at a price of $1,000 par value per individual bond.
A bond like any other investment isn’t risk-free. Credit risk or the issuer’s failure to pay interest or principal leads to a default on its bonds.
Among the biggest bond risks, inflation can reduce purchasing power, making the fixed income becomes less valuable over time.
Bonds can also be subject to liquidity risk, which is when the market lacks bond sellers and buyers and the investor is forced to sell at a price lower than expected.
With that said, investors don’t control the bond entirely to its maturity date. And certain steps should be taken to minimize bond risks, such as diversifying bond holdings and buying bonds at stable interest rates.
What are the types of bonds?
Here are the main types of bonds you can find in the market.
A popular example of this is the bonds issued by the US Department of the Treasury on behalf of the federal government. This type of bond is also known as sovereign debt or, in the US, treasuries.
It is the safest bond investment since there are no risks and it can benefit from tax advantages at the state or local unit.
Types of US Treasury Instruments include:
- Treasury Bills – short-term securities with maturities of 30 days to one year
- Treasury Notes – long-term securities with maturities between two and 10 years
- Treasury Bonds – other long-term security with maturities greater than 10 years.
- Treasury Inflation-Protected Securities (TIPS) – offer protection against inflation because it is based on the movements of the Consumer Price Index. TIPS have maturities of five, 10, and 30 years.
These bonds are issued by private and public corporations. Issuing bonds is more favorable to companies rather than bank loans in terms of interest rates.
These corporate bonds are subject to federal and state income taxes.
Agency bonds are often referred to as government-agency bonds since they are affiliated with government organizations. These bonds are also subject to federal tax but exempt from state and local taxes.
For instance, Federal National Mortgage Association or Fannie Mae and Government National Mortgage Association or Ginnie Mae facilitate funding in mortgage, educational, and education lending programs.
Municipal bonds, commonly referred to as “minus,” are issued by states or municipalities to fund local projects. The risks may depend on the revenue return of certain projects or the credit quality of the company.
Unlike other types of bonds, municipal bonds offer a tax exemption in federal tax as well as state income tax. There are three types of municipal bonds:
- General obligation bonds – issued by governmental entities backed by “full faith and credit” and taxing power under the jurisdiction.
- Revenue bonds – finances specific projects that guarantee an income. It covers interest and principal payments.
- Conduit bonds – a governmental entity issues bonds available to a private entity. The conduit borrowers agree to pay the governmental issuer who pays the principal and interest on the bonds and they are responsible for debt obligations.
The advantage of bonds
Bonds could be an excellent investment. It is more advantageous to investors with a relatively low tolerance for risk such as retirees who oftentimes assign a high value to assets that produce income.
Bond gives you two potential benefits to having a good portfolio. First, you can help reduce risk in volatile investments such as stocks. Second, they can provide a flow of returns while preserving the capital.