Bonds are a debt securities issued by governments and corporations as a way to raise money for a particular purpose or to pay costs of a specific project. The persons who buy the debt are called bondholders or investors who, in exchange for loaning their money, receive interest as a stream of income that will be paid over the life of the bond. Return of principal can be a primary reason for buying bonds because it allows for the preservation of your money.
Buying bonds can be one of the quickest, simplest, low risk ways to start investing and generate a predictable stream of income from investing. Multiple bonds can be purchased so that the predictable stream of income is received monthly over a long period of time.
U.S. Government Bond
Government bonds are issued by the Federal government to finance government operations and interest paid on these bonds is taxable income. The federal government has various types of Treasury notes and Treasury bonds that can be purchased on an regular basis in increments of $25, $50, $75, $100, up to a maximum (which can vary from year to year). Purchasers set up an account and specify the type of bond they will purchase, the amount, the source from which the purchase will be made, and how the frequency (one-time, bi-weekly, monthly, quarterly, or annually). There is 24 hour access to your account which lets you see the type, number, total amount, and interest payments paid on bonds you have purchased.
Municipal Bond
Municipal bonds are debt securities issued by states, cities, counties, and other instrumentalities authorized by the state to issue bonds. These bonds are issued to raise capital for a particular purpose or finance a particular project. Municipal bonds can be issued as taxable or tax-exempt, but are primarily issued as tax-exempt. A couple of major incentives for purchasing municipal bonds is the interest paid to bondholders may not be subject to federal or state income tax and historically states have not defaulted on their debt.
An example of how a municipal bond works is: the City of Chi needs money for a new elementary school and therefore decides to issue a $20m general obligation bond with an interest rate of 2% to be paid twice a year and return of principal to be paid once on year Jan. 2, 2020 through Jan. 2, 2050. The minimum amount any one investor can make is $5,000. An investor makes a $5,000 purchase and will receive two interest payments every year and one principal payment. As a bondholder, you will also receive documents from the City of Chi with details about construction and use of the project, the source of city revenue that will be used to pay the interest, how interest payments are calculated, and dates you will receive an interest payment and principal payment.
Corporate Bond
Corporate bonds are issued by private and public corporations to raise capital for various purposes and projects. An example of how a corporate bond works is: ABC Corp. wants to raise money to pay research and development costs of a new produce and therefore decides to issue a $300m bond with an interest rate of 4% to be paid once a month and return of principal to be paid once a year on Jan. 2, 2020 through Jan. 2, 2040. The minimum amount one investor can make is $5,000. An investor makes a $5,000 purchase and will receive an interest every month Jan. 2, 2020 through Jan. 2, 2040 and one principal payment on the final maturity date. As a bondholder or investor, you will also receive documents from ABC Corp. with details about the research and development project, the designated source of funds that will be used to pay interest and principal, how interest will be calculated, and specific dates you will receive interest and principal payments.
Corporate bonds are issued by for-profit corporations. While interest paid on corporate bonds is subject to income tax, the interest rate is usually higher which is an incentive for purchasing these types of bonds. An incentive for purchasing Government bonds can be the minimum amount needed to get started, the ease of purchase, and the historical guarantee of the federal government paying its debts.
Before investing in bonds
It is important to understand that provisions of the different categories of bonds are usually different each time a bond is issued. The primary reason this is important because of the likelihood of payment of interest and return of your principal. Therefore, prior to purchasing a bond one should read the materials provided by the issuer so that you understand the circumstance upon which interest will be paid, how much you will be paid and when, and what constitutes a default and what to expect if there is one.
In addition to understanding provisions of a bond issuance, you should understand bond terms such as issuer, underwriter, conduit borrower, financial advisor, discount, premium, yield, rating, coupon, interest rate, bond mutual fund, municipal bond, corporate bond, debt service, issue date, final maturity, variable rate, fixed rate, collateral, secured bond, unsecured bond, callable bond, convertible bond, CUSIP Number, Treasury bond, Treasury note, TIPS, EE bond, I bond, and a host of other terms.