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What Are Bonds?
There has been hearing lots of talk in the news recently that bond yields have been rising, and we've been receiving a lot of inquiries as to what bonds are, and how they work. Today we will discuss an overview of these questions.
Bonds are debt purchased by an investor from an institution such as a corporation, or government. Institutions will sell bonds to help raise capital for purposes like expanding business development, or perhaps to help provide capital to complete a project. When an investor purchases a bond, they essentially are buying a company's debt. Bonds can be attractive to investors because they provide two ways of potential growth or income for the investor.
The first way bonds can provide income for investors is through the interest rates which bonds pay. Bonds pay interest on a predetermined schedule, which is often semi-annually. The bond holders are able to generate an income from this interest rate while they hold the bond. This is one of the reasons bonds are popular in income portfolios of investors.
The second income bonds can provide is from the intrinsic value of the bond potentially increasing. As an example, let's say an investor were to purchase a bond from a company for $1,000 that pays 3% interest annually. The company then issues new bonds of $1,000 each that pay 2% interest annually. This means that the 3% bond could be seen as more attractive, and the investor eventually sells the bond for $1,050. The seller will have earned any interest that was payable from the bond while he/she held the bond, and then also earned $50 or 5% on the sale of the bond as well.
Bonds are also attractive to investors because bond holders are considered creditors of the bond issuer. This means that in the event that the bond issuing company were to go into default, bond holders are paid from remaining funds before stock holders. This does not mean though that bonds are guaranteed, or come without risk. Bonds follow a rating system to help investors have an idea of the default risk of the company, but that does not mean that there is a guarantee of the bond holder receiving back their investment. Bond's can also lose intrinsic value and lose of the sale value of the bond should the bond holder choose to sell the bond.
Like any investment, there are many different types of bonds, and choosing a bond that is appropriate for your goals can be challenging. If you are considering adding bonds to your investment portfolio, or have questions about bonds and investments you currently hold, schedule a meeting with us and one of our financial professionals will be happy to answer your questions.
*This hypothetical example is for illustrative purposes only, and its results are not representative of any specific investment or mix of investments. Actual results will vary