A bond is a debt instrument. The term debt instrument is often the part that confuses people , in the sense of how can you invest in a debt? Let me explain. When people need to raise money to buy a home or a car, they often seek a loan from a financial institution such a bank. The bank will issue a loan to that person on the grounds they show substantial ability to pay back the loan. The benefit for the bank or the other financial institution that issues the loan , is that they charge interest on the loan. When you take out a loan you have to pay back more than the amount you borrowed, this amount is subject to the interest rate. Often when the debtor (the person borrowing the money) is considered to be a high risk candidate the higher interest rate charge will be. The same applies with bonds. Bonds are rated on the basis of risk, the higher the risk , the higher the interest rate.
How does a bond work?
A bond is a debt instrument as we explained above, that allows you to earn interest. A company or a government institution will issue bonds in order to raise money. So when you invest in a bond, you become the creditor and the company that issues the bond is the debtor. So if we could put it in simple terms you become the bank who issues the loan and gets paid interest back. Instead of using the term loan ,we call this a bond. The amount you use to invest in bonds, is called your principal amount. Each bond has a maturity date, the date in which you principal amount has to be paid back. While you hold the bond you also earn interest (payments), these may be paid annually , bi-annually etc.. You do not have to hold the bond for the whole maturity period. However the idea behind a bond investment is that it is going to be a long term investment.
The benefits of bonds?
Bonds are considered as a low-risk and conservative investments. Another benefit of bondholders is that they take priority over shareholders. Therefore if the company was to become bankrupt, the bondholder will get paid out first before the shareholders.
The risk of bonds?
Bonds are considerable low risk investments, however if the credit rating of the company decreases, it poses a threat to the bond issued.
Should you purchase bonds?
Bonds are expensive , and they cannot be bought by individual investors they need to be bought through a professional broker. This increases the expenses in owning the bonds. However, you can still get the benefits of the bonds markets at a cheaper cost by investing in ETF- Bonds. With ETF – Bonds you are able to get exposure to the bond market at much lower cost and still reap the benefits. To learn more about ETFs follow the link ().