Bonds Explained for Beginners

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A bond is a type of loan issued to some type of entity such as a business or government by an investor.

It’s similar to borrowing money from a lender if you’ve ever purchased a home or car before.

Sometimes businesses need more money than the banks will offer them, so they issue bonds as a way to raise more capital.

Governments can also issue bonds when they need more money for things like roads or parks.

Bonds are considered safer on the risk spectrum for investments, but they also typically carry a lower return.

Benjamin Graham, author of the intelligent investor and Warren Buffets mentor, recommends holding a portfolio of 75% stocks and 25% bonds during a bull market and 75% bonds and 25% stocks during a bear market.

As opposed to other investments which are considered equity, bonds are considered debt which means that if a company goes under, it must repay all bondholders before stockholders. This is due to the fixed interest nature of the bond.

When the investor purchases a bond at what’s called the face value, they are paid interest, known as the coupon or yield.

The reason it’s referred to as coupon is because back when bonds were actually paper, investors would physically have to clip coupons to redeem their interest.

Anyway, the investor is paid a coupon on the bond until the loan is fully paid back by the issuer. This is known as the maturity date.

Interest payment frequency and the maturity date is determined prior to the purchase of the bond.

For example, if I purchase a $1,000, 3-year bond with a 5% coupon, I know I’ll receive $50 in interest each year for 3 years.

Now it’s important to note that Bonds can vary in risk and return

A AAA bond is the best bond you can buy while a Ba bond and lower are more speculative and are known as Junk bonds

When it comes to bonds, the higher the return, the higher the risk. The lower the return, the lower the risk. Bonds with a longer maturity date are also riskier and carry a higher return. Typically government bonds will be safer than corporate bonds.

When it comes to taxation, corporate bonds are taxed regularly while some bonds like municipal and other government bonds are tax-exempt.

A bond can also be secured or unsecured

With an unsecured bond, you may lose all of your investment if the company fails while with a secured bond, the company pledges specific assets to give shareholders if they fail to repay their bonds.

Although bonds are considered a “safer” investment, they still do come with risks.

When you purchase a bond, interest rates are out of your control and may fluctuate.

Interest rates are controlled by the U.S. treasury, the federal reserve, and the banking industry.

This means that if specified in your agreement, the company may be able to issue a call provision which is an early redemption of the bond.

While not always the case, companies will take advantage of lower interest rates to pay back loans early. This leaves you with a lower return than what you expected.

Bonds are also inversely proportional to interest rates so when interest rates go up, bonds go down and vice versa.

Bonds can also be traded between investors prior to its maturity date. A bond that’s traded below the market value is said to be trading at a discount while a bond trading for more than it’s face value is trading at a premium.

Bonds can be a great way to diversify your investment portfolio, however, they can also be quite complex.

You can use investment platforms like Fidelity, E-Tade, or Charles Shwabb to learn more about specific types of bonds.

For today’s video, we will be using Fidelity.

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Disclaimer: Nothing published on my channel should be considered personal investment advice. Although I do discuss various types of investments and strategies, I am not a licensed professional. Please invest responsibly.

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