Similar to cash investments, bonds involve giving your money to an organisation as a loan. The organisation then uses your money to fund their business plans, pay you an interest payment as part of the arrangement.
The interest payments received on a bond are called ‘coupons’. Coupons are typically paid on a regular basis, which could be every 3 months, every 6 months or every 12 months. Bonds are usually issued with a fixed timeframe, where the organisation agrees to pay the original investment back in full at the end of the agreed timeframe.
So, when you invest in a bond, you receive a regular coupon (interest payment) as well as your original investment when the fixed period comes to an end. For example, if an investor buys a 5 year bond that pays an annual coupon of 5% for $100, they would receive $5 a year as an interest payment as well as the original $100 5 years later.
There are two main types of bond, which are government bonds and corporate bonds.
Corporate bonds are usually seen as being riskier than government bonds. This is because companies use bonds to grow their business, which comes with a risk of failure. As a consequence, there is a greater risk that investors will not receive their money back from the company. To account for that risk, companies tend to offer higher rates for their bonds, in order to attract investors. Corporate bonds typically offer returns of anything from 3% to 13%.
Obviously, the risk of failure is much more likely to happen in smaller companies than in larger companies. Therefore, investors can expect to receive a larger return on a bond issued by smaller companies than a larger company.
Government bonds, on the other hand, are considered to be less risky as the government of a country has the ability to print more money. So, if a government struggles to meet their debts, they can print more money to cover them. As a result of this, government bonds are considered to be risk-free, especially when it comes to the bonds offered by developed countries. Government bonds tend to offer low returns, which usually range from 0.5% to 2% a year.
How you invest in bonds, depends on whether they are corporate or government bonds.
When it comes to government bonds, is it usually the case that investors can buy them directly from the government. It is common for governments to offer a service that allows ordinary people to purchase bonds. For example, in the UK, individuals can purchase government bonds through the Debt Management Office.
Corporate bonds, on the other hand, can be purchased through a stockbroker that offers bonds. So, if you want to invest in bonds, you need to find a stockbroker that will enable you to do that.
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