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While the investment space is dominated by traditional stock markets like the NYSE and NASDAQ, people are often unaware that the global bond arena is a multi-trillion dollar industry. In fact, bonds can be one of the safest and easiest ways to earn passive income.
If you’re interested to find out how these financial instruments work, be sure to read our comprehensive guide. Within it, we’ll cover what they are, how they work, the different types of bonds you can invest in, how much you should expect to make, and anything else we think that you should know.
What Are They?
When a large company or government decides that they need to raise more money, they will often make the decision to issue bonds. Investors will buy these instruments from the institution in question, and in return, the investor will receive interest. In this sense, investors are essentially loaning the money to the institution, at a cost.
While the terms outlined in a bond agreement can vary quite considerably, here is an example in its most basic form.
- You purchase $10,000 worth of bonds from a US company
- The instrument pays an annual interest yield of 4%.
- The bonds will expire in 4 years.
- At the end of each year, you will receive your 4% interest payment. This works out at $400.
- You will once again receive this 4% interest payment at the end of year 2, 3 and 4.
- After the 4 years, the bonds will expire, meaning that you will get your original $10,000 back.
As you will see from the above example, you did not get your $10,000 investment back until they expired. This is known as the ‘Maturity Date’ in the bond space. However, during the 4 year period, the bonds paid you $400 (4%) in annual interest, amounting to a total figure of $1,600 over the course of the agreement.
In effect, this allowed you to make passive income, insofar that you were not required to do anything once the bonds were purchased.
What You Need to Know
Before you purchase bonds, it is important that you understand how they work. First and foremost, each bond will have its own risk levels attached to it. As you probably know, the ‘Risk vs Reward’ model dictates that the higher the risk, the higher the rewards.
Therefore, as the risk of the bond issuer increases, as should the annual yield that it pays. For example, let’s say that you purchase a set of bonds from the U.S. government and another set from the Venezuela government.
Which set do you think will pay the highest amount? The Venezuela bonds will, of course, because the risks of default are significantly higher.
You also need to make considerations regarding the term of the bond. In theory, the longer the term of the agreement, the higher the risk.
Think of it like this. Let’s say that you lent $500 to two separate friends. You agreed that one friend could pay you back in 1 week, and the other in 10 years. Which of the two loan agreements do you think are riskier? Well, the 10-year agreement would be significantly riskier.
The reason for this is that anything could happen in that 10-year cycle and thus, there is a much higher chance that you will not receive your money back.
This is exactly how bond terms work. You see, the longer the agreement, the more chance there is that the issuer will default. As such, you should expect a higher rate of interest as the term increases.
Finally, it also worth remembering that bonds will always pay the same rate of interest during the term of the agreement, as long as you hold on to them until they mature. We’ll explain this in more detail in the next section.
Can I Sell Them Before They Mature?
Whether or not you can sell your bonds before they mature will depend entirely on the type of bond you are holding. For example, if you are holding instruments issued by the US government (known as US Treasuries) then you can sell them at any given time.
The main reason for this is that the trading of US Treasuries is a highly liquid market. In other words, as there is so much demand for them, you’ll never have a problem finding a buyer.
It is crucial that you understand that by selling your bonds before they mature, you stand the chance of getting less than what you paid. You see, prices will fluctuate much in the same way that stocks and shares do.
This is based on market forces, which is dictated by the underlying risk of the bonds. As such, if the markets think that the risks are higher (in comparison to when they were first issued), then the value of the bonds will go down.
On the other hand, a secondary market doesn’t always exist. For example, if you invested in savings bonds (also known as Certificate of Deposits or CDs), then in the vast majority of cases you will need to hold on to these until they mature.
Ultimately, if you are looking for a way to earn a fixed, passive income, then we would suggest holding on to the bonds for the duration of the term. That way, you will always receive the same amount of interest, and you don’t face the risk of selling them for less than what you paid!
So now that you understand the basics of how these instruments work, in the next section, we are going to explore who issues them.
Who Issues Them?
As we noted above, bonds are issued by either large-scale companies or governments. Both issue these instruments as a way to raise capital.
When governments have a short-fall in their domestic budgets, they will issue and sell bonds. In reality, this is just another way of printing money, as it is ultimately the taxpayer that will foot the bill. Nevertheless, government bonds can be both low risk and high risk, depending on the issuer.
For example, bonds issued by the likes of the US, European Central Bank, UK or Australia, are typically viewed as risk-free. If one of these nation-states were unable to meet their payments, then they would simply print more money to cover the short-fall. As such, the only way that you would lose your money is if the government in question no longer existed. If this was the case, you would have far bigger problems to worry about.
On the other hand, government bonds issued by countries with less-than-favourable economies are super high risk. Over the past two decades, the likes of Uruguay, Argentina, Ukraine, Russia, Pakistan, Moldova, Belize, Nicaragua, Ecuador, the Dominican Republic, and Jamaica have defaulted on their sovereign bonds at least once.
While it is true that these countries have the capacity to print more money, the underlying currencies are not in strong global demand. As such, printing more money will have little effect other than devaluing the local currency.
Alongside government bonds, we also have corporate bonds. As the name suggests, these are large corporations that are typically listed on major stock exchanges like the NYSE or NASDAQ.
Much in the same way as government bonds, corporate bonds can be both low risk and high risk. However, in the grand scheme of things, corporate bonds are considered to be higher risk than those issued by governments.
The main reason for this is that the possibility of a company going bankrupt is significantly higher than that of a nation-state. Moreover, unlike government bonds, corporations do not have the option of simply printing more money in the event of a potential default.
As such, you should expect to make a higher rate of return when holding corporate bonds, especially ones issued by under-performing companies.
So now that you know the two types of issuers, in the next section, we are going to explore the different types of bonds that you can invest in.
What Types of Bonds can I Invest in?
Terminology in the industry can seem somewhat confusing at first glance. One of the overarching issues is that terms are often conflicting. Nevertheless, while we have already discussed government and corporate bonds, we’ve listed some of the terms that you are likely to come across below.
Fixed-Rate: Unless you are looking to trade bonds on the open marketplace, then you should only consider fixed-rate bonds. This is where the amount of interest paid on the bonds remains the same for the duration of the bond agreement.
In effect, while the likes of US Treasuries can be sold before they expire, they are still fixed-rate bonds, insofar that as long as you hold on to them until maturity, the rate of interest is fixed.
ETFs: Bond ETFs (exchange-traded funds) allow you to invest in the market without actually owning the bonds. Instead, you are speculating on whether the value of the bond will go up or down in the open marketplace. On the one hand, by investing in a bond ETF, you will not be entitled to any of the interest payments that the bond represents.
While this might sound counterintuitive, one of the overarching benefits of investing in a bond ETF is that they give you access to otherwise difficult-to-reach markets. For example, bond ETFs make it super convenient to invest in bonds issued by foreign governments. Ordinarily, this particular segment of the bond space is reserved primarily for institutional investors.
Municipal: Municipal bonds are very similar in nature to those issued by the government, however, they are issued at a state or even county level.
These bonds pay a much higher rate of interest than those issued by the federal government, albeit, they are also a lot riskier. Municipal bond issuers do not have the option of printing money like the US Treasury, so do bear this in mind.
Mutual Funds: If you are already familiar with what a mutual fund is, then you’ll know that they are tasked with managing your investments on your behalf. This works in the very same way a bond mutual fund.
In a nutshell, the fund manager will buy, sell, and trade them on the open marketplace, with the view of making short-to-medium gains. Mutual fund managers will rarely hold onto the bonds until maturity, as they instead look to make smaller, more frequent gains.
How Much Will I Make When Investing in Them?
The amount of money that you can make when investing in bonds will, of course, depend on the specific bonds that you buy. While listing thousands of bond yields is beyond the remit of this article, we’ve listed a few examples below to give you an idea of what you should expect.
The amount of interest payable on US Treasury bonds will usually increase as the maturity date gets longer. For example, at the time of writing, a 5, 7, and 10-year bond will pay 1.793%, 1.904%, and 2.031% per year in interest, respectively.
As you can see, the yields on offer are super low. However, don’t forget, US Treasuries are as close to risk-free as you are going to get, and thus, this is reflected in the annual yield.
In order to showcase the disparity in government bond rates, we thought we would highlight the bonds issued by the Turkish government. For example, a 10-year bond will pay in the region of 14.9% per year. This is absolutely huge. However, this is for good reason.
With the Turkish Lira in freefall against the US dollar, alongside a stagnant domestic economy, the risks are significantly higher. In reality, it is highly unlikely that Turkey will default on its bond payments, although, never say never.
You might be wondering why a company that is currently in possession of $245 billion in cash reserves would issue bonds (Apple Bonds). Well, it has, and at a rather juicy coupon rate of 3%. Once again, this is a rather conservative yield, albeit, the risks of Apple defaulting are virtually non-existent.
At the other end of the corporate scale, international money transfer company Western Union has issued bonds with a maturity date of 2036. By holding on to these instruments for a mere 17 years, you’ll be paid an annual yield of 6.2%. As such, a $10,000 purchase would result in an annual interest payment of $620, meaning that when the bonds do eventually mature, you would have doubled your money.
Worth it? Probably not, as taking into account the underlying risk of the Western Union model, a lot could happen in those 17 years!
In summary, if you’ve read our guide from start to finish, we hope that you are no longer asking yourself “What is a bond?”. In fact, you should now have all of the required information to determine whether or not these financial instruments are a good investment for your individual needs.
As you hopefully now know, this arena is one of the broadest sectors in the investment industry. Nevertheless, the overarching takeaway is that much like in the case of the traditional stocks and shares space, you need to assess the underlying risks and rewards of a bond before you part with your money.
If you’re looking for a practically risk-free way of earning passive income, then you have the likes of US Treasury bonds. Alternatively, if you are looking for a higher rate of return, and thus, you have a slightly higher appetite for risk, then you might consider investing in corporate bonds.
Either way, just make sure that you assess the risks of each before you make an investment.
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Ricardo is an entrepreneur, investor and personal finance nerd who enjoys spending time with his family and friends, travelling and helping others achieve their financial goals. Ricardo has been quoted as a personal finance expert in several online publications including Healthline, Bankrate, GOBankingRates, MSN Money, Yahoo Finance, U.S. News & World Report, Forbes and USA Today.