Tuesday, July 29, 2008

Investing basics - bonds

You know that you need to invest, and you know what types of accounts you should be investing in, but what actual investments should you make inside of those accounts?

Most of your investment will be stocks, bonds, or a combination of the two.  Often, you will be able to invest in stocks and bonds through a mutual fund.  Mutual funds are a great way to invest and I will talk more about them in coming days.  Because stocks and bonds are the building blocks of mutual funds I first want to make sure that you understand what they are and how they work.  Today, I will cover what bonds are and how they work.  Like most of my posts, this is a quick overview designed to give you enough information to make wise decisions about your money.  If you want to go more in depth on this or any other topic, there is much more information out there.  If you leave me a comment or send me an email, I would be happy to help you find it.

Bonds are loans.  When governments or corporations need to raise money, they often issue bonds.  When an investor like you purchases the bond, you are loaning your money to the government or company in exchange for a regular fixed payment.  The interest rate of the bond determines the payment that you will get for owning the bond.  For most types of bonds, this interest rate can never change.  Bonds are issued for a set period of time, generally thirty years or less.  At the end of that time period, the issuer of the bond will repay the loan to the investor.

For example: ABC Corporation needs to raise money to expand their business.  You purchase a 30 year bond with a 5% interest rate from ABC for $1,000.  Every year, for the next thirty years, ABC Corporation will pay you $50 in exchange for the $1,000 loan you gave them by purchasing the bond.  At the end of the thirty years, you will have received $1500 in payments and ABC will return your $1,000 to you.  So this bond turned your $1,000 into $2,500 over the course of thirty years.  Not bad, eh?

While you can choose to own the bond for the entire 30 years, you can also sell it to another investor should you choose.  If you sell the bond from ABC, it might be worth more or less than the $1,000 you paid for it.  Investors will look at other bonds that are available.  If the 5% interest rate on your bond is better than the interest rate that similar bonds are paying, then your bond might sell for more than $1,000.  However, if other similar bonds are paying interest rates that are higher than 5%, then your bond will not be an attractive investment, and will be worth less than $1,000.  This price fluctuation only matters of you sell the bond.

Bonds are not risk free.  If ABC's business goes poorly (think Enron) and ABC goes bankrupt, you could lose some or all of your money.  Therefore, in order to encourage investors to purchase bonds from less financially sound organizations, these organizations need to offer higher interest rates to investors.  So the riskier the bond is, the higher its interest rate will be, and the safer a bond is, the lower its interest rate will be.

That covers the basics of how bonds work.  Tomorrow, we can learn about stocks.

1 comment:

Best Way to Invest Money said...

Keep your investments simple, and stick to mutual funds that have solid three to five year track records and low expenses. You can even opt to have the fund company make automatic monthly withdrawals from your bank account to force you to save.