What in the World Is a Bond?

A Bond is a certificate of debt. If you hold a bond what you hold is a certificate stating that whoever issued that bond owes you money. When most people think of Bonds the first thing that comes to mind are probably the government bonds that their grandmothers bought for them and held to maturity and then gave to them as a gift for their 18th birthday. These bonds are issued by the U.S. government and are historically known to be risk-free, which they are. The only way you could lose your money is if the U.S. government were to go broke. We all know that will never happen. These bonds are issued by the U.S. treasury. What happens when you are investing in bonds is that you loan the government your money for a set period of time. The Government then pays you interest on that loan every year. When the term of the loan has run out or as they say in financial circles, when the bond has matured, the government then gives you back the money that you loaned them in the first place. Sounds like a sweet deal right? It could be. The upside to investing in bonds with the United States Government is that there is virtually no risk that you will lose the money that you invested and you will be earning interest on that money until the bond matures. The downside to investing in bonds is that although you will never lose the amount of money that you invested there are other factors in play that can cause the purchasing power of the money that you are investing in bonds to decrease. Translation: You will still be given back the amount of money that you invested in the first place but that money will be worth less than it was when you invested it. This is caused by inflation.In short when I say that your purchasing power can decrease what I am saying is that your your $100 can buy 30 gallons of gas today but it will only be able to buy 20 gallons of gas a year from now. Same money, less gas. That is the number one problem with Government Bonds. Fortunately the Government also knows that this is a problem and since they need to keep the bond money coming in to support all of the spending they do they created a solution for this problem called Treasury Inflation Protected Securities.

Treasury Inflation Protected Securities are essentially the same as regular bonds. What makes Treasury Inflation Protected Securities different is that you do not get a standard rate of interest when you invest in Treasury Inflation Protected Securities. What happens is that the interest rate that you are paid on your money is equal to the rate of inflation. Like all things, investing in bonds in this way is beneficial under certain conditions and harmful under others. If you were to be invested in Treasury Inflation Protected Securities while the rate of inflation skyrocketed to double digits like what happened in the mid to late 1980’s then your Treasury Inflation Protected Securities investment would make you very happy. However, if the rate of inflation is only 2% while the rate of interest paid out on the regular treasury bonds are 4% then you would be missing out on potential profits. I am a fan of Treasury Inflation Protected Securities because when investing in bonds in this way your money will never lose its purchasing power and that alone is worth the price of admission.

There are many strategies that can be used when investing in bonds by the Government. These bonds are risk-free and are a good way of preserving your wealth. However,government issued bonds are not the only bonds on the market.

Municipal Bonds: The U.S. government is not the only governmental entity that relies on raising money to pay its bills. Municipal Bonds are bonds that are issued by a city or other local government or their agencies. Municipal Bonds are riskier than U.S. government Bonds and for that reason Municipal Bonds usually pay a higher rate of interest than U.S. government bonds. One of the reasons that an investor would prefer to invest money in Municipal Bonds is because of the fact that more often than not the interest paid to the bond holder is exempt from federal income tax and from the income tax of the state that issued the bond. This is a big deal because tax fee growth is the best kind of growth there is.

Corporate Bonds: Corporate bonds are one of the few things in the world of finance that is exactly what it sounds like: Bonds issued by a corporation. When corporations need to raise money they will usually issue stock. That is standard procedure. However, issuing stock means diluting the value of the previously issued shares. This is not always a viable option and so to get around doing that a company will issue corporate bonds. Corporate bonds can be extremely risky or they can be extremely profitable depending on the company whose debt you purchase. The upside to Corporate Bonds is that the interest paid out on the debt is more often than not more than any U.S. or municipal bond. Another upside is that if the company goes bankrupt the bondholders are paid before the shareholders. The downside to investing in corporate bonds is that if the company goes bankrupt and there is no money left after liquidation then it does not matter who gets paid first because nobody will be getting paid at all.

Investing in Bonds is essential to almost every portfolio because they are a good hedge against the volatility of stock. Historically when stock prices go down, the interest rate on bonds go up and vice versa. I did not go into all of the different types of bonds there are because my goal is only to make you aware of their existence. However, if you want more detail then follow my blog as I will be blogging about all of the different types of bonds in the near future.

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