The basics of buying bonds

Most traders operate the stock market with the objective of winning large amounts of money. Whether it is for future savings or if they are day traders, investors seek to gain profit through buying and selling stocks. Trading stocks is an excellent activity since it is volatile and traders can see the effects that the news and global economy have on the assets they trader. Many earn large amounts of money by investing in stocks, but there is another financial instrument that is just as valuable, but it is much less volatile and risky.

These financial instruments are known as bonds. When the prices of stocks are rising, bonds are perceived as a useless mean of investment, but when the market happens to be on a downtrend, bonds are viewed more favorably thanks to their solid stability.

Bonds are a way of borrowing money. Companies and governments need to issue bonds to gather funds for developing projects that will allow them to earn more capital. Companies and governments do not ask for loans on banks because the amounts required are quite often too large for it to be profitable. The company or government then proceeds to issue bonds to a certain market. Investors then proceed to buy these bonds which can be later sold for profit. The entity that issues the bond has to pay an additional fee in order for investors to look forward into lending their money; this fee is an added interest which becomes real when the bond reaches the date when the issuer has the obligation of paying the borrowed amount.

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We can easily illustrate this through an example. If you buy a bond that is worth $5,000 with an interest of 10% and a maturity date of 5 years, it means that each year you will receive 500$ a year for that period. As soon as the bond ends its period, you are bound to receive your investment back.

There are three main types of bonds. The first and most common are corporate bonds, which are issued by companies that need to gather funds so they can take off their business. There are municipal bonds issued by lesser government entities; these often come with exemption of taxes of some kind. Lastly, there are government bonds whose terms depend on the maturity period. Every government issues bonds differently and some issue bonds only to certain entities. It depends on the state of the economic policies of the country itself. Some corporate bonds allow the creditor to convert its invested amount into company shares, which can serve as a useful conversion in many cases.

The main difference between bonds and stocks is that shareholders have a say when it comes to company decisions, while also being secured some sort of profit. But investors that buy bonds are creditors, which only serve to lend money to the company. Creditors’ payments are of higher priority than those of shareholders, but this refers only to the interest entitled to the ownership of the bond; shareholders obtain part of the profits earned by the company as a whole.

The bond’s interest rate is also known as “coupon” because it was quite common that the actual bond possesses coupons that you may redeem for a fixed amount of interest; nowadays this is performed electronically most of the times. The period in which the bond will be repaid is called maturity. Maturities can be of several decades, one year and there have been cases of a hundred years. The shorter the maturity, the lesser risk there is on buying the bond; this is due to the price changes that are bound to happen in the market. The longer time an asset is exposed to the market variables, the higher rate of fluctuations.

When buying a bond you must take into consideration who is the issuer of the bond. The most trustworthy bond issuers tend to be the governments. Governments are (most of the times) able to pay back their bonds to their creditors; this is due to taxes, which serve as a stable source of capital. Every company has a rating when it comes to bonds. Agencies such as S&P and Moody’s offer ratings on the companies that have the best guarantees as they issue their bonds.

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The most common way of buying bonds is through brokerage agencies that allow you to do so. The thing is that these companies usually require large amounts as initial investment to operate on your behalf. A solution is to participate in a mutual fund whose objective is to trade bonds in financial markets. Government bonds usually can be bought through federal agencies such as the treasury, which allows investors to not use a broker so they get full advantage of the benefits offered by the bond. When you buy a bond through a broker, make sure that the price stated corresponds to the price of the bond on the market. Most of the times, brokers make profits by charging an additional amount on the price of the bond itself, which allows them to benefit from the interest that it generates over time.

Bonds are a way of ensuring profits at a steady but slow pace. This financial instrument is unique in its own way because it enables investors to surely assess the situation of the economy as it is. Because bonds have a fixed return outcome, the expected return of a bond is always predictable. Bond prices adjust quickly to the current status of the company or government, so the expectations are clearer than they are when the investor aims to trade stocks or commodities.

The general rule is that you should invest in bonds if you cannot afford to risk money to gain profits in the long term. If you’re a seasoned investor that is about to undergo a MBA, you may transpose your investments into bonds so that your earnings are secured; but at the same time, you will reduce your potential amount of profits to be earned.

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