When government, municipality, private institution, or a corporate company etc are planning to expand their business and are in need of funds to meet their needs, they raise the money by issuing bonds to public. The bonds are offered with pre-set terms and conditions like rate of interest the security will bear; their maturity date, alternate choices that investors are offered on the bonds etc. Basically by buying bonds, the investor agrees to lend money to the company against which he will be paid a fixed or pre-defined rate of interest on bond reaching its maturity date.
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Interest on Bonds
Different companies will issue different kinds of bonds offering different interest rates. Some bonds may pay yearly interest and they may be held for the period of 3 years or more; some may decide to pay half yearly interest and some even pay monthly interest. The rate of interest and how it would be remitted to bond holder is entirely up to the company offering the bond. It is considered that higher the interest rate the bond bears, the more risk it carries.
Who Should Invest in Bonds
Bonds are most appropriate for investors those who are looking at safekeeping of principal investment and earning healthy returns on it. There are several types of bonds, & all of them come with their own unique features; zero coupon and convertible bonds being most common of them all.
Risks Associated with Investing in Bonds
The most risky aspect of investing in bonds lies in what’s known as the bond spreads. The new investors are especially not aware of it when they begin trading. For frequent buyers and sellers of bonds this spread can cost the trader a lot by way by hefty hidden expenditure which for some investors I know has run into losses worth thousands which they did not realize until it was late. It’s therefore better than beginners are aware of this aspect before anything else and make the moves forward cautiously.
Rule for Investing For Beginners
Beginners often want to know what portion of their income or wealth they should invest in bond. Well, the answer is simple – it is a rule that was devised by the famous author and an Ivy League tutor B. Malkiel, who prescribed that the percentage of wealth that one should invest in bonds, should be equal to one’s age.
Meaning, for a 35 year old investor 35% of her or his income every year should be invested in bond and likewise 40% of income for 40 year old. It’s a simple straight rule which works very well for people if they commit to run with it for 10-15-20 years; especially people using automatic dollar cost averaging plan which is based on indexing.
Types of Bonds
There are different types of bonds and likewise there are different ways to invest and hold them. For example people looking for tax rebates should opt for government bonds because there no taxes are levied on income earned by way of interest. On one had they are very safe but on the other they will pay very low rate of interest.
Then there are US saving bonds, before investing in which, it is again considered important that the trader patiently studies about various aspects in detail. Next come EE Saving Bondsare distinct in its feature because they offer tax relief when it comes to creating funds towards education; they come with the guarantee of the United States Treasury, they earn its investor a fixed rate of return that can sometimes even extend the period of thirty years etc. Then another type of bonds which come with government guarantee and backing, and the interest rates are based on inflation in economy, are called Series I Saving Bonds.
Beginners sometimes also get confused whether to invest in bonds directly or invest through bond funds and play safe. It will do traders a great deal of good if they take time and study about benefits, characteristics, and disadvantages associated with both types of investment before taking a plunge. Because both happen to be good options in their own ways but making an informed decision is all that there is to investing and earning good returns over it. Then come Junk Bonds. They lure new investors like nothing does, because it boasts of earning high returns for the trader that beats every other type of interest any other bonds can make; but traders should always steer clear of these carrots. They are an extremely dangerous investment and hardly earn any returns for their clients.
The investors while getting familiar with the many aspects of bond will also realize that preferred stocks released by companies from time to time can be compared with bonds because they both operate on same lines.
It is also advised that investors wishing to put in their money in bonds should become familiar with flip sides of investing in them. For example, they should study aspects such as, how investors can get hurt by bond spreads; also these investors should evaluate and understand duration of bond vis-à-vis the fluctuation that these bonds experience; another aspect to get acquainted with is the drawbacks of investing in foreign bonds and so forth.
These are some of the basics of investing in bonds. Once trader is thorough basics he should touch upon the advanced topics related with bond investment which may include topics pertaining to bond yields resulting from variation in value of bond over a period of time and so on.