At the beginning of my financial journey the term bond was floating around amongst the multiple other words I had no clue about. I threw it to the side because in my mind I thought it was just another word for a term deposit.
Oh how I was wrong.
I mean there are certainly similarities between the two but they are in no way the same thing.
A bond is a type of fixed income that an investor receives through becoming a lender to a borrower. This meaning the investor (you) buys what's called bonds which is money you are lending out to a borrower (usually the government) in return for a fixed interest payment over a certain term. The borrower borrows the money usually for a business adventure. After that bond term is completed you receive back 100% of what you put forward (assuming the the borrower has not gone bankrupt) and benefit from all the interest payments.
Details of Bonds
Bonds are a fairly simple concept to understand. You the investor become a lender for a borrower and therefore will receive interest on the money that you lend. However you do not get to decide the % of interest you can charge on your money. Most commonly (and more safely) governments will issue out bonds to lenders or investors. When the bonds are issued out there are terms associated to the bond issued.
Some of the important terms will include:
An issue date (date that the bond begins)
A maturity date (date the bond finishes)
A coupon rate (the % of interest you will be paid on your money and at what times)
There are many other details that are put on the terms sheet but for simplicity we will stick to these major 3. Now many people would just say why don't you go for the highest coupon rate! Get as much bang for your buck! And rightfully so, however like any investment, there is some degree of risk involved.
Risks associated with bond investing
Now don't take my advice as legal advise! However bonds tend to have a lower risk associated to them compared to other types of investments. The terms are all laid out to you initially, you know what % a year you will make on your money and for how long. The risk comes from who you lend your money to!
If you had the option to lend money to your friend or a stranger and in return they say they
"I will give you your money back and some more in a few weeks!"
I know which one you would choose straight away. It is a no brainer you would choose your friend. Now lets say your friend says:
"If you give me $100 I will give you $120 in 4 weeks"
and the stranger says
"If you give me $100 I will give you $200 in 4 weeks"
What would you choose....
The risk level stays the same being the stranger is way more riskier to lend your money to rather than a friend. However this time the stranger is offering a better return for your money.... Now I know this does not completely relate to bonds and .I may have gone overboard with the hypothetical as borrowers are much more reliable than a stranger however the concept is similar. As a lender you choose who you are wanting to lend your money too. In real world terms borrowers are either governments or large organisations trying to fund certain projects. And as a general rule of thumb organisations are going to have a much larger chance at going bankrupt and hence losing your money (they are the stranger). Opposed to if you were to lend to the government where the chance of your money completely disappearing is very low.
HOWEVER the catch is and as the saying goes the riskier the investment the higher the possible returns (high risk, high reward.) Meaning organisations will issue bonds with a higher coupon rate (interest on your money) opposed to government issued bonds. It is up to you what risk level you are willing to take when it comes to buying bonds. Many well known investors put large portions of their investment portfolios into bonds but it all comes down to what you and your financial adviser decide is best for your situation.
What you have to think about before you buy a bond
Before you buy a bond there are many factors you may want to think about. Like any investment it is essential you check that you are in the right financial state to be able to invest. And after that it is advised you learn and research about the investment before pursuing it.
None the less when it comes to bonds in my opinion it comes down to 3 main things:
1. The risk you are willing to take: Some people are young and have their whole lives ahead of them so naturally are happier to take on more risk if that means there is a greater return. Whereas older people closing in on retirement are looking to look after their money hence take a more conservative and careful approach. Often looking for the least amount of risk involved.
It is up to you to decide how much money you are willing to risk (aka if you were to lose all of the money you invested would that put you in trouble financially). And whether this risk equals the reward involved.
2. The length of the bond: Some bond are more liquid than others. That meaning the ability you are able to access your cash. Usually if you choose to withdraw your money before the maturity date of a bond you will be harshly penalised and your return will be significantly less. Hence you want to have the mindset before you purchase a bond that the money you give over you are happy to not see it for the length of the bond (e.g. 5 years, 10 years or however long this bond may go for).
3. What return will I get: Bonds are a fixed income. Pretty cool hey! Means you put forward your money and agree to get payments at certain periods (see bonds details) for the length of that term. It is essentially an extra income you get for a certain time. Hence you are going to want the best return! This relates closely to the risk involved in point number 1 being if you are willing to take on a large risk for that greater reward. Going through bond terms and finding the ideal return on your money proportional to the risk involved is essential in the process.
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Disclaimer: Young Money Investing is not a legal financial adviser. It is advised you seek legal advice before actually investing your money. Young Money Investing aims to help inspire, inform and reach your financial goals.
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