Bonds are financial instruments, specifically, debt instruments.
Debt instruments (not to be confused with drums and guitars) are an essential part of the economy and part of a balanced investment portfolio.
A bond is a loan, and you’re the lender.
What are bonds for?
Sometimes a company, municipality, or government needs to raise funds. They might need funds to grow, develop, finance projects or operational costs, facilitate activities…or even make the payments on previous bonds.
An investor (that’s you) can then loan money to the company or government by purchasing those bonds. But why would you want to loan a company or government your hard-earned cash?
The answer is a fixed-interest rate. Depending on the kind of bond it is, you should know when and with how much interest you’ll be paid back. You know how much money you are going to receive in interest in addition to getting the amount you lend back, and when.
Bonds are known as fixed-income securities.
Are there different kinds of bonds?
It is important to note that all bonds (and all debt) are not created equal. Some debt is rated highly, and other debt is rated poorly.**
Highly-rated debt is called investment grade.
This indicates that the entity to which you are loaning your money has a very high chance of paying you back. Non-investment grade debt is sometimes called junk.
Examples of Investment Grade Debt:
- The United States government.
- Major corporations like Disney.
- Financial institutions like J.P. Morgan.
If a company isn’t rated as investment grade, they need to increase the incentive to buy their bonds, and they usually do this by offering a higher interest rate or coupon.
What’s the coupon rate?
When talking about bonds, the coupon refers to the annual interest rate paid on a bond.
For most bonds, payments of this interest occur at the predetermined rate and schedule (remember the fixed part of fixed-income security).
Once upon a time when bonds were pretty pieces of paper rather than electronic transactions, coupons were bits of paper torn off of a bond and redeemed. Suddenly the term coupon makes a bit more sense.
Coupon rate vs. par value
Par Value is the value the bond has on its maturity date. This is the value of your bond, it’s what you pay, and it’s printed right there on the bond. Bonds can have different maturity rates, from as little as a month to 100 years.
The maturity date is the the day you get back the money you initially invested. This is your principal.
Now you know more about bonds!
Learn more about how bonds can fit into your portfolio here.
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