A bond is a loan. That’s it.
You loan your money to a Government or a Corporation and they promise to repay you the money you lent to them at a certain date in the future.
To make it worth your while, they also pay you interest every 6 months. From the get go, you know when you’re supposed to receive your interest and how much it’s going to be.
If the Corporation or Government fails to pay you the interest on the dates that were set out, they are in “default”. You can then take legal steps against them because they had a legal obligation to pay you.
There are bonds that are backed up by specific assets like equipment and real estate. If you own this kind of bond (called “collateralized bonds”) you can sue and try to get the assets that back up the bonds. If your bonds are not backed up by any specific assets, you are a general creditor and in a less secure position. As a result, unsecured bond holders demand higher interest rates than secured bond holders.
As I said, when you buy bonds, you know when you are supposed to get your money back and when you’re supposed to collect your interest. As long as you hold on to the bonds until they mature, and as long as the issuing body is solvent, you’ll get your money. But if you need to sell your bond before they mature, you may get more or less money for those bonds. The reason is that interest rates change.
Generally, as interest rates in the market rise, the value of bonds drop. That’s because the interest on bonds that have already been issued is fixed. The interest payment you receive doesn’t go up or down as I mentioned. That being said, if interest rates are higher today than they were a year ago (for example) a new investor could get more interest on her investment if she buys new bonds. If that’s the case, the only way you’ll be able to sell your bonds in a rising interest rate environment is to ask less than what you paid. Makes sense?
So the value of your bonds is determined by how long it will be until they mature. Generally, the longer the maturity the greater the risk (more time for things to go wrong). Also, if the company encounters financial trouble, the bonds are going to go down in value. That’s because nobody else will want to buy them from you if they can buy more secure bonds at the same price.
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In short, if you own bonds, you have to think about how long until they mature, how strong the issuer is and where interest rates are.
Are bonds the best investments to make now?
Over the last year, lots of investors pulled money out of the stock market and dumped that cash into bonds. Especially those who want to have enough money to retire.
That’s because they were afraid of investing in the stock market and needed some place to park their money. So, because so many people were competing to buy bonds, the prices went up. As the prices rise, the return goes down (relative to the money you invested in the bonds). If you buy a bond that pays 4% and has a face value of $100,000, you will receive $4000 in interest every year and that won't change. But if you paid $110,000 for the bond because you had to compete with other investors to buy it, you earn much less than 4% on your money. Right?
With rates at historic lows and with many States and Municipalities facing severe financial challenges, do you think this is the time to buy bonds?