Bond Basics for Beginner Investors

Bonds are one of the simplest and safest types of financial securities, and they make up a large part of many portfolios. Despite this, many beginner investors don’t understand bonds and believe they are too complicated to bother with. That’s why I wrote this post to cover bond basics. Hopefully, this will help you get started with a solid foundation understanding of bonds.

Think of bonds as the foundation of your portfolio, a stable and safe base upon which you can build the rest of your portfolio. Just like the foundation of a house, you want the foundation of your portfolio to be safe, stable, and long-lasting.

When you want to purchase something large like a new home, you go to the bank and they lend you the money you need to buy the house. When big corporations or governments want to make a big purchase, they can’t go to the bank because the bank doesn’t have enough money to lend out to pay for large, government-sized purchases. Instead, to raise the money they need governments and corporations will sell bonds, which is basically a promise to pay the owner of the bond interest payments in the future.

A bond will have a specific size and number of the payments that will be paid, as well as a specific period of time these payments will be made during. Basically, a bond is a loan that you can make to corporations or the government.

Bond Basics

Understanding bond basics starts with the language and terminology. The language used to describe bonds can be confusing at first, but is rather simple. The length of time of time that a bond is valid is called the maturity of the bond. Bond’s with a one year maturity are bills. Bonds come with many different maturities.

The price of the bond is how much you will pay to buy the bond, and the face value of the bond is the amount of money given to you at the end of the bonds specified time period. The size of the interest payments is expressed as an interest rate.

Let’s look at an example:

If Bob buys a government bond with a 3 year maturity with a price of $10, 000.00, a face value of $10, 500.00, and an interest rate of 5% paid annually, then

-Bob spends $10, 000.00 initially to buy the bond because the price of the bond is $10, 000.00.

-At the end of Year 1 the government pays Bob a $500.00 interest payment.

-At the end of Year 2 the government pays Bob a second $500.00 interest payment.

-At the end of Year 3 the government pays Bob a third payment of $10, 500.00 because the bond has matured and $10, 500.00 is the Face Value of the bond.

As you can see, Bob has garnered a 15 percent total return on his investment. This is pretty good for a bond, especially considering interest rates at the time of this writing.

You’re probably somewhat familiar with interest rates. You know when you put your money in a savings account? Have you ever wondered what that 0.075% meant?

Interest rates are what a lender charges a borrower for use of their asset. This is calculated in percentage of the asset. So, when you see that 0.075%, that is how much the bank will pay you per year to borrow your money in the savings account. Interest rates are important for bonds, as they help dictate the return of a bond.

The final step to understanding the basics of bonds if you’re a beginner is to determine how much risk there is on a bond. Just like a mortgage, if a large corporation or government goes bankrupt, it can default on its payments. Most of the time this is very rare, and a bond is a very safe investment. To date the government of Canada has never defaulted on a bond. As a general rule, bonds from corporations are riskier than government bonds, but often come with a higher interest rate to compensate for the added risk. Like meat, bonds are graded, with AAA bonds being the safest, then AA, then A, then BBB etc.

When you’re a beginner just getting started, understanding bonds can seem boring and dry. While this is true, it is still important to understand how they work. Stay tuned for future posts about stock/bond comparisons and how you should manage your portfolio properly.

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