Bonds are a very common investment product (or vehicle) that people often don’t know much about. So how can you understand what bonds are?
Bonds are a form of debt taken out by corporations or governments. This is one way that large corporations or governments can raise money for projects they want to work on.
The bondholder provides money to the issuer (borrower) for a set period of time. This is essentially a loan from the bondholder to the issuer. The two most common forms are municipal bonds, issued by local governments, and corporate bonds.
Nearly anyone, company or organization can be a bondholder. If you have a 401(k) or pension plan, some of that money is likely invested in bonds.
Bonds, especially municipal bonds, are considered one of the safer ways to invest money.
Interest is usually paid to the bond holder during the life of the bond and the original amount (or principle) is returned at the end. It’s like a bank paying you interest on your savings account or you paying interest on credit card debt.
The end date of the loan is called the maturity date; at that time the borrower pays back the bondholder the original amount of the bond.
The bondholder gets a set amount of money paid in interest at agreed upon intervals, such as every few months. That interest is called the coupon.
Like all investments, bonds carry risk. Sometimes corporations or governments don’t have the money to pay back the bond at its maturity date, and they default on the loan. The issuer may default on the loan or, in some situations, pay it back early.
It’s not very common but it does happen. For example, the cities of Detroit, Michigan and Stockton, California declared bankruptcy in the early 2010s, in the fallout of the last recession. Their debt was renegotiated so bond and other debt holders only got a small portion of their money back.
Bonds can also be traded on the bond market, so bond holders can sell them ahead of time if they want or purchase them after they’ve already existed for some time. In that case, the price of the bond may have gone up or down (like a stock). Their value is generally pretty stable, however.
Generally, money you make from bonds and other investments is taxable income. Interest made on corporate bonds is taxable. Interest paid on municipal bonds, however, is often tax-free or at least exempt from taxes paid to the government that issues it.
For example, if I live in New York City and buy a bond issued by a New York City, the interest I make on that bond won’t be taxed by New York City, New York State or the federal government. If I live in New York City and buy a bond issued the State of Texas, I will have to pay local and state tax on the interest earned but not federal tax.
Municipal bonds may offer the additional benefit of providing tax-free income. You’d need to look at each bond to determine its tax status
Bonds are important to know about to understand the US financial system and common investment types. This piece is for educational purposes only. Consult a qualified investment advisor for information on specific investments.
Money Funnies does not sell, buy or in any other way promote investments.