How do bonds work?

Tyler York
How Bonds Work - A Visual Guide

How Do Bonds Work

What is a bond?

Bonds are a bigger part of finance than stocks, even though they get a lot less attention. Unsexy but mighty, bonds represented $39 Trillion in net value worldwide in 2015, while stocks were worth approximately $26 Trillion. A bond is a Security, like a stock, and is a type of investment. We’re going to go into bonds quickly here – if you prefer a video, Brandon Rith, Basic Wisdom founder and Achievable FINRA SIE author, has a short video on the topic of bonds that our post is based on. 

How do bonds work?

Bonds are an investment that returns a fixed income over a long period of time, often 10 to 20 years or more. The investor gives a company or government a lump sum of money, which is called the Principal. The investee then pays the investor interest every month at an agreed-upon rate for the length of the investment period. At the end of the investment period, the investor receives the final interest payment and then gets the Principal back as well.

How Bonds Work - A Visual Guide

Sweet deal, right? Well not always – there are tradeoffs and risks to consider.

Risks and Tradeoffs with Bonds

The main tradeoff is that while bonds are consistent and expected money, they often return less than stocks or other investments precisely for that reason. You’re earning a little bit less return in exchange for it being less risky. Second to consider is the risk itself: if the bond is to a company, that company may go bankrupt or otherwise not be able to repay bond payments or the principal itself. This is also true for a country, though less common. This is why bond ratings (AAA, AA, etc) are so important and have such an impact on the price (interest rate).

To use Brandon’s example, let’s say you were interested in investing into a bond for Tesla, the car company. In this example, let’s say the bond has a 20 year duration, it pays 5% interest annually per year, it pays that interest monthly, and you can purchase bonds in $1,000 chunks. This is a pretty typical structure. You’d give Tesla your $1,000, and Tesla will then pay you $50 of interest per year through two semi-annual payments of $25 each. The risk for you would be that Tesla could go bankrupt or choose not to fulfill bond interest payments for a time due to a recession or other troubles.

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