What are investment bonds and why should you care?
If you’re planning to buy your first home, you might have heard of investment bonds or have wondered if they’re right for you. First of all, what are they? Well, investment bonds are assets that don’t pay out income in the way that stocks and bonds do, but instead appreciate in value over time. Basically, you buy something, hold onto it and let it increase in price until you sell it later on down the road, thus making money off the price difference between when you bought it and when you sold it. So are they right for you?
The Basics of Bonds
Bonds aren’t like stocks, but they aren’t really loans either. A bond is a debt security—an IOU from an issuer (usually a government or corporation) to a holder. When you buy a bond, what you’re essentially doing is loaning money to an organization in exchange for regular interest payments (the coupon) and your eventual repayment of principal at maturity. If a bond's issuer defaults on interest payments or doesn't repay your loan on time, then it can be said that your investment has been defaulted or busted. So what are investment bonds? Well, we have some bad news: They're not guaranteed by grandma. In any case, it’s easy to see that a bond’s value changes according to its risk. As a rule of thumb, as interest rates rise, prices fall; as interest rates fall, prices rise. That’s because if an investor can get more interest from another security, he or she will usually sell his or her existing bond and buy one with a higher coupon rate. Likewise, if an investor can get more money for his or her money elsewhere, then he or she will usually sell his or her existing bond in favor of one with lower returns (i.e., higher yields). This is known as yield chasing—and it happens all the time in financial markets.
Government Bonds
Investment bonds issued by various levels of government—including federal, state and local governments—are considered extremely safe investments because they almost always pay back your money. For example, when you buy a United States Treasury bond (what most people think of as a government bond) with your $1,000 investment, that government pays that $1,000 right back to you over time plus interest if your bond is sold later at auction. Your payment schedule varies depending on which kind of government bond you purchase. That's true for other kinds of investment bonds as well: For instance, many states sell so-called revenue-backed investment bonds (essentially an IOU for services rendered) that pay back your money within 30 years. Public companies also sell investment bonds, typically in one of two forms: corporate or municipal. Corporate investment bonds represent a loan to a corporation that pays interest—also known as coupons—at regular intervals over its lifetime. Municipal or local government investment bonds provide loans to cities, states and other local governmental entities. You can buy these through your brokerage or through your bank. Municipalities pay interest on their investments from tax dollars, so most people assume that these are safe investments. In reality, local government investments carry significant risk of default if too many investors choose to cash out at once during an economic downturn.
Corporate Bonds
In their most basic form, investment bonds are a way for companies to borrow money to meet short-term and long-term goals. Some corporations have tax-free status, meaning they can only raise funds by issuing corporate stock. In that case, they’ll issue a corporate bond (typically called an indenture) to raise capital. These corporate bonds often have higher interest rates than consumer or government debt (like mortgages), because investors aren’t taxed on that income. Keep in mind: Issuing debt is also a riskier move for corporations than it is for consumers—if a corporation defaults on its loan, bondholders can pursue it in court for payment.
Municipal Bonds
When it comes to investment bonds, there's one type that trumps all others: municipal bonds. They’re also called Muni’s or tax-free bonds. Because of their tax status, these government investments pay interest that is free from federal income taxes for all investors — not just those in high-tax brackets. As a result, these investments yield more than similar taxable alternatives such as corporate or Treasury bonds. At your local bank or online broker, they can help you explore all your options with several ways to access municipal-bond offerings: Direct purchase. This means buying straight from a state, city or county government agency that issues the bond in question.
Understanding interest rates
The interest rate is usually a percentage of your principal investment, so when it goes up, so does your principal. Let’s say you invest $10,000 in an investment bond with a 4 percent annual interest rate. In one year’s time, that investment would be worth $11,000 (not including fees). Then let’s say interest rates rose to 5 percent; your next year’s return would be $11,500. The more risk you’re willing to take on—the higher-risk investment bond—the higher your potential return. That all sounds good until it doesn’t: When interest rates go down (as they have been), so does your potential for profit from an investment bond.
Maximizing Your Investment Income from Bonds
One of your first challenges as an investor is to come up with enough capital to invest. In a world where a million dollars sounds like a lot of money, you'll quickly find out that it won't get you very far when buying investments. Luckily, if you're willing to be a little more patient, there's another option that can help you grow your wealth quickly—and without taking too much risk: investment bonds. Investment bonds are actually debt instruments that is issued by a corporation or a governments. They pay interest on a regular basis, which you then reinvest in additional investment bonds to generate even more income down the road. Investment bonds also provide liquidity (the ability to sell) at any time, meaning that unlike stocks, which have no set price until they're sold on an exchange or over-the-counter market (OTC), you know exactly how much your investment bond will be worth at any given time. This makes investment bonds ideal for investors who don't want their investments exposed to market fluctuations while they wait for them to mature.
