Bonds are key investment vehicles that belong in the portfolios of most serious investors. Bonds can be intimidating but in actuality they are fairly straightforward. If you purchase a bond you’re simply loaning your money in exchange for a monthly return on your loan. The amount your pay depends on the interest rate or coupon of the particular bond you purchase. The Loans if made to a bank are commonly used to fund things like mortgage or student loans. If they are a bog for a company they will be used as the company sees fit, but not normally.
Bonds are typically purchased in increments of $10,000. For example, if you purchase a one bond for $10,000 and the rate of return is 6%, you’ll receive monthly payments. Bonds also have an associated term or time period such as 10 or 30 years. Notably, you will also receive the amount of your loan, known as your principal, at the end of the term of the bond.
Investors in these bonds are loaning their money in return for a fixed rate of return. The fixed rate of return is one reason that bonds are such an importatant investment vehicle. If the bond’s rate of return is 7%, then this is what the investor will receive. This is in contrast to stocks where the investor has no control over the eventual return.
There are several types of bonds available for purchase. One of the most popular types of bonds is known as municipal or “muni”. A municipal bond is issued by a local government when they need to raise funds for a particular project. For example, if a local government needs to build a school, stadium bridge or other similar infrastructure project, they will raise money by issuing municipal bonds.
Municipal bonds are very popular investments for those who are in the higher tax brackets. This is owed to the fact that municipal bonds are not subject to federal income taxes. This means that their actual rate of return can be higher than the coupon amount unlike and ETF. How much higher depends on which tax bracket you’re in.
While many investors tend to think of bonds as fairly conservative investments, they can in fact be volatile. While the coupon of the bond stays fixed, the price that investors are willing to pay for a particular bond can and will change. This is because of the fact that what people are willing to pay for a particular bond will fluctuate depending on current interest rates. For example, if you own a bond with a coupon of 8% and current interest rate are 5%, a investor is willing to pay you a “premium” for your bond. This premium will be reflected in increased price of the bond.