Apart from helping conglomerates to mobilize funds by issuing stocks, Wall Street also enables them to raise money through the release of bonds. In theory, a bond is an investment that offers a fixed income and is circulated by a business house of the government. A bond provides the investor with a regular and predetermined rate of interest for a particular period of time.
If you wish to comprehend what bonds are, you need to reason like a banker or pawnbroker rather than a shareholder or depositor. In any case, a bond is supposed to be an I.O.U. or a promise to pay. Once you purchase a bond, it means that you are offering your money to a conglomerate or the government to use it in lieu of a pledge that the amount will be refunded to you in its entirety along with the agreed interest sum.
Speaking in terms of bonds, let us suppose that when you buy a bond, the business house or government, whosoever is issuing the bond, guarantees to reimburse you a pre-determined interest fee of seven per cent every year. This pre-determined or assured interest rate is also known as a 'coupon'. As long as you will be holding the bond or till the validity of the bond you are assured that you will be given this fixed interest rate. When this period ends or on the maturity of the bond you will be refunded the money you had spent to purchase the bond. Meanwhile, the interest paid to you during the period from the purchase of the bond and its maturity date will be yours. In other words, the interest is the return on the money you had invested in purchasing the bond.
It may be mentioned here that there are actually three kinds of bonds available - Treasuries, munis and the corporate or those issued by business houses. The bonds that are circulated by the United States government are known as the Treasuries and they are deemed to the most secure bond as they are totally endorsed by the United States government. On the other hand, the munis are circulated by the state as well as the local governments and these are more often than not tax-free investments. In contrast, the bonds issued by the conglomerates are very chancy, but they offer the maximum rate of interest. In fact, the return on your money will be the highest from corporate bonds in comparison to the other two that have different levels of government backing.
In addition to this, there are three different groups of bonds depending on their period of maturity - bills, notes and bonds. Bills are bonds with the minimum terms or maturity dates ranging from one month to a year. The notes, on the other hand, have maturity dates that vary between one to 10 years. The bonds have the maximum maturity dates that may vary between a minimum of 10 years and a maximum of 30 years. Typically, the rate of return on investments made in bonds depend on the term of their maturity - the longer the maturity period, the greater the earnings. It has been seen that normally people who detest taking an adequate amount of investment hazards are likely to purchase bonds instead of investing in stocks. When you invest in stocks there is enough possibility of losing all your money if your the stocks you have invested in plunge drastically and their value becomes naught. You will be sorry to learn that that even investing in bonds is not completely secure. The fact is that risks are also involved in purchasing bonds.
Any person who has purchased a bond is always worried regarding the interest rates that they would be receiving on their investment. In any case, for the majority of the people who purchase bonds the interest sum they collect from their investment in bonds is their sole earning or source of sustenance. It needs to be mentioned here that the Federal Reserve System, or the Fed, brought down the interest fees over 12 times following the period when the stock market maxed out in the year 2000. Investors who had already purchased different bonds were very happy over the development as they had already gone in for advantageous returns at more high interest rates and were in a position to sell their bonds again at an elevated price. In any case, the worth of a bond increases whenever the interest rates drop.
In fact, the transposed liaison between the prices of bonds and the interest rate are very puzzling for everyone. Actually, majority of the people never comprehend that the price at which they obtained their bonds when they were issued increases or plunges in the reverse direction with the interest rates - the system known as the inverse relationship. For instance, suppose an investor has bought a bond for $1000 with an 8 per cent coupon and hence the investment offers an annual return of $80 on the face value of the bond at $1000. Now, if the interest rates in the stock market fall lower than the 8 per cent, the value of the bond will be in excess of $1000 as other investors would now be willing to pay more to obtain the superior rate of interest on the bond concerned. Contrarily, when the interest rates go up in the stock market, the value of the bond will be lower than $1000 as no one will pay even the face value of the bond ($1000) as it is now paying a lesser interest rate than what is prevailing in the market.
To be precise, the benefits of purchasing a bond includes receiving a fixed interest rate for a specified period and the guarantee that the money or principal amount you have spent to purchase the bond will be refunded to you in full on the maturity date of the bond. In other words, when you purchase a bond, you are lending an amount of money to a business group or the government on the promise that you will be receiving a pre-determined interest rate for a specific period of time and the refund of the money in full once the bond matures. However, purchasing bonds has its shortcomings too. It is possible that the corporation issuing the bond or from whom you have purchased the bond may collapse and go out of business. Despite this, more people purchase bonds compared to investing their money in the stock markets, which is seen as a highly risky venture. It may be mentioned here that bonds are especially preferred by people who are close to their retirement.
If the bonds appear to be perplexing to you even after the above discussion, there is no need to worry because the bonds are really confusing. This is one reason why people chose to purchase bond mutual funds that are more suitable and simple to comprehend.