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Fundamentals of Bonds

Original post by Wanda Thibodeaux of Demand Media

Investing your funds is a way to let your money work for you, as funds you invest can grow based on market values, accrued interest and tax-deferment. You can put your money in any number of different investments, including bonds. If you've never done this before, it can be a little confusing and even scary -- after all, you don't want to lose your funds -- but learning the fundamentals of bonds may keep you more financially secure by allowing better portfolio allocation and diversification.

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Definition

A bond is a promissory note an organization provides to a lender, similar to an IOU. It indicates that the owner of the bond is entitled to receive funds from the issuing organization on a date in the future. Because they show that the issuer owes something to the buyer, bonds are a form of debt security.

How Bonds Work

When an organization needs funds but doesn't want to take out a regular loan, it offers bonds to the public. Buyers purchase the bonds, with each bond payment essentially being a miniature loan the organization must repay at a later date. The buyers cannot cash in their bonds until the bonds reach the date for repayment. Some bonds have a very short amount of time until they mature and the buyers can cash them, but most bonds are long-term investments held for several years. If a buyer needs to cash in the bond prior to the date of maturity, he may do so, but he faces a penalty and therefore loses some of the value of the bond. If a buyer waits until the bond matures to cash it, the company pays him at least the full face value of the bond. Some bonds also accrue interest, but not all bonds do.

Types

Bonds come in many different forms, including municipal, corporate, government, mortgage- and asset-backed and foreign government. Bonds issued by governments tend to be more secure because they are backed or guaranteed by treasury departments. In addition to defining bond types by how they are issued, bonds also are grouped according to factors like interest, redeemability and price. Organized this way, bonds may be regular, callable or zero-coupon. Regular bonds, which are what most bonds are, are purchased for a portion of the face value and gain interest. A callable bond is one the issuer can pay off, or call in, prior to the date of maturity. A zero-coupon bond does not pay interest, but they are offered at very low prices. For any bond, the term "coupon" refers to the interest rate provided and the date of maturity the bond has.

Risk

When a person has a bond, they have a promise that the issuer will repay a debt. Put another way, the buyer has some guarantee of a payout or return on his investment. For this reason, bonds typically are considered very safe investments, especially if issued by a government. The price paid for this low risk, however, is a lower return potential -- unlike a stock, which can provide a return several times the investment amount, bonds usually don't earn an investor as much money. This, of course, depends on the investment strategy of the buyer. If a buyer is able to purchase good bonds with high interest rates and reinvests his earnings, bond earnings still can be substantial. To minimize the risk of loss, people usually do not put all of their money into bonds. Instead, they spread their resources over many different types of investments in order to diversify their portfolio.

How to Invest

Because each person has very individual financial plans and needs, there is no one-size-fits-all strategy when it comes to bond investing. However, in general, financial planners usually advise people to invest in higher-risk investments earlier on in life. One way to interpret this is that you should invest in fewer bonds overall when you're young, but you cannot cut bonds out entirely because they are always part of a diverse portfolio, which is important at any age. The second way to interpret the advice is to purchase the same number of stocks but invest in stocks that are riskier -- and which therefore have higher interest rates -- earlier in life. Either way, the general rationale is that if you end up losing money when you're young, you still have some time to make up lost financial ground.


                   

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About the Author

Wanda Thibodeaux is a freelance writer and editor based in Eagan, Minn. She has been published in both print and Web publications and has written on everything from fly fishing to parenting. She currently works through her business website, Takingdictation.com, which functions globally and welcomes new clients.


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