Before making any purchase decision, one should have a clear understanding of what is being purchased. Many people purchase bonds simply because they sound safe without really understanding how they work. Here is a closer look at their basic workings.

The basics of bonds

Bonds are issued by companies, governments and municipalities as a means to raise money. These issuers are basically the borrowers and those purchasing the bonds are the lenders. The issuer of the bond will be in agreement to pay back the face value (principle) of the bond and a set amount of interest over a given period of time.

Risks inherent in bonds

Bonds are not without risks. There is the danger that the issuer will not be able to pay, and bonds can fluctuate in value. Overall though, bonds are usually a much safer investment than stocks.

What do bonds pay?

Since the rate of return on bonds varies with the level of risk, there is no set rate of return. Those with a higher risk will pay a higher rate of return. On the other hand, when there is very little danger, the issuer of the bond will be able to sell them at a lower rate.

What makes them fluctuate in value

Even though the issuer has agreed to repay the principle of the bond back in full, they still fluctuate in value when traded on the open marketplace. One reason for this is interest rates. If a long-term bond is locked in at a lower rate when interest rates are rising, it will drop in value since investors will want to dump it for other investments. The opposite will be true when rates are moving the other way. This is one of factors that can change the market value of the bond.

What to look for when buying bonds

The first thing anyone buying bonds needs to consider is the level of risk they are willing to take. While higher risks brings higher returns, it also can potentially bring bigger loses too. Every bond investor must decide on what level of danger is acceptable for them before buying.

Longer term bonds of 15 years or more are likely to see greater fluctuations in value with changes in interest rates. This also needs to be taken into consideration when purchasing bonds.

Investors should be careful not to go for a bond just because it is tax exempt. Keep in mind that tax-exempt bonds will pay lower rates. The amount lost from these lower rates usually will not be worth the tax savings they can bring unless the investor is in a higher tax bracket. Calculate the savings offered from being tax exempt against the lower rate of return before purchasing.

Other things to take into consideration

When looking at what types of bonds to buy, buyers should look at fee structures. Fees, particularly in bond funds, can eat up a lot of investment over time. Look at sales charges and expense ratios before making any purchases.

Above all, bond investing requires the same caution and common sense any investing does. Do not be rushed into buying anything over sales pitches. Always do careful homework first.