In very simple terms, bonds are just loans. Bonds are effectively just a note saying that a certain group, which can be a business or government or other entity, will pay back the bondholders a certain amount of interest at certain intervals, then pay back the whole loan amount at the end of the loan period.
Generally, bonds are considered less risky than stocks. This is why the interest rate – or return on investment – from bonds is usually lower than the average investment return on stocks. However, that is not a guarantee that all bonds have no risk. There is always a chance that a business could fail or a government will go bankrupt, and bonds are priced based on that risk. The more risky the project is, the less expensive the bond is – or in other words, the more risky the project is, the higher interest rate a buyer will need to receive to be compensated for that risk.
Who issues bonds?
Bonds are used to finance projects or businesses. If you own a business and want to start a new location, you would rather take out a loan than sell part of your ownership in the business, because you think your business will be worth a lot more in the future. Once you pay back that loan, you are done with the obligation and you know exactly how much that will cost you before you enter into that agreement. But if you sell off shares of ownership in your business (also called equity), then you are selling the permanent rights to future profits from your business. In the long run, selling equity can be much more expensive than taking out a loan.
Instead of going to banks for a loan, large businesses and even governments will solicit investors for bonds that they issue. An example of this would be a town trying to build a bridge. They do not have the money in the budget for a bridge, so they issue a bond that investors can buy in order to fund that project. A group of investors will buy the bonds, the town will use that money to build the bridge, and then the town pays back the investors with interest over time.
Why would I invest in bonds?
This is a great question: if I can make more money from buying stocks, why would I buy bonds? The answer is diversification. Diversification refers to having a mix of high risk and low risk investments. If you only have high risk investments, then in some years you will make a lot of money, but in other years you might lose a lot of money. By having a mix of high and low risk investments, you can have more consistent growth in your money.
Most people will choose less risky investments for money that they will need soon. For example, if Jane Doe is saving money for a deposit on her first house, she will probably need that money soon. That means she would not want to invest the money in stocks, because she could lose it and then would not have the money when she wants to buy the house. Instead, she might invest in bonds, which are less risky than stocks but will still provide higher interest rates than savings accounts, so her money will continue to grow.
Similarly, when people approach retirement age, they tend to invest more heavily in bonds than in stocks. This is because they will soon need the money to pay their bills in retirement, so they do not want to risk losing the money on stock investments. Bonds are a safer option for older individuals who still want to growth their money without too much risk.
How can I invest in bonds?
Bonds can be broken up into a lot of little individual pieces. Using that same example of the small town raising money to build a bridge, that town may place that bond on a public “bond market”, which is very similar to a stock market. Individuals can go to that market (which is now online for investors) and buy a piece of that bond for the bridge project, and in doing so will help fund that bridge. That investment will sit in their brokerage account just like any of their stock investments would.
Accordingly, the process to invest in bonds is very similar to the process for investing in stocks. You open a brokerage account, use a broker or website to buy a specific bond, and then the investment lives in your brokerage account.
The additional complication with bonds is that most people do not want to buy individual bonds. To help with this, banks and other financial services companies have developed “bond funds”, which are investment vehicles made up of many different bonds of varying lengths and for different projects. Investors can buy part of the bond fund, which is the equivalent of buying a little piece of a lot of different bonds. This is done through the same process of buying through a brokerage account.
