Bonds, Bonds, and More Bonds

I’m sure many of you have heard the term bonds before, whether it be because of finances or maybe even your high school history class. Now some of you might be wondering how bonds are related to history, or why your history class out of all classes would teach you about bonds. Continue reading if you want to learn about the history of bonds, the different types of bonds, and how you can invest in them. 

The History of Bonds: 

First, let’s learn about the history and importance of bonds. The concept of bonds first originated in circa 2400 BC in Nippur, Mesopotamia, but we are going to focus more about its purpose in the United States. Bonds first began to gain prominence in the United States during the Revolutionary War. In order for the United States to fight the war effectively they needed money. The government issued bonds to the public in an attempt to raise enough finances for the United States to maintain the war effort. The idea was that the public, if they bought a bond, would pay the government an amount of money which they would receive back at a later time with interest. In a sense, it was a loan that the public was providing the government based on the agreement that they would receive that money plus some more, at a later time. A bond essentially represented that agreement as an insurance policy. 

These bonds were government issued bonds, but it is crucial to remember that there are different types of bonds and we’ll get more into what that means a little later. Bonds during this time was a method devised by the US government to accumulate the finances necessary for war. Today it is still a way for the government to raise money but it is also a common method of diversifying your portfolio and investing with hypothetically, less risk, 

Different Type of Bonds:

Now we are going to talk about the different types of bonds and the different levels of risk a bond can be given. As we know, a bond is an agreement that can be issued by the government. In this segment we will learn that a bond can also be issued by a corporation, which is what results in the varying degrees of risk that can be associated with a bond. A bond is also paid back in increments with a little interest added, every year. This takes place until the original price of the bond is returned by the corporation. 

First, let’s learn about the three basic types of bonds:

U.S. Treasury Bonds: 

Treasury bonds are fixed-interest debt securities issued by the US government. They have a fixed interest rate, which means that the amount of interest applied to the bond will stay constant throughout the years it is in effect. Debt-securities are essentially financial assets that are created when one party is financially indebted to another. In this case, the financial assets are bonds. U.S. treasury bonds also have a low maturity period. This means that the amount of time it takes to pay back the original principal is less, typically lower than one year. 

Thus, leading us to risk. Because of the low maturity and its issuer being the US government, treasury bonds typically have a very low level of risk. This means there is a very high chance that your money will be paid back in full principal, the only drawback is that this results in less accumulated interest. Which ultimately means less overall profit. 

Municipal Bonds: 

Municipal Bonds are debt-securities issued by the local government and state in order to fund civic projects. The advantages of municipal bonds are that they are tax free and exempt you from federal and local-income tax. This is to compensate for the low interest rates, which are typically lower than the interest rates of treasury bonds. But similar to treasure bonds, this means there is less risk which is also an advantage. This is also known as default risk, which is the risk a lender faces when determining whether the borrower will fulfill the required obligation. So the lower the default risk, the more likely the borrowed money will be returned but this also means less interest. Typically government and state issued bonds have a low default risk, since they are dependable and stable corporations. 

Corporate Bonds: 

Corporate bonds are debt-securities that are issued by firms and sold to investors. These types of bonds are typically where there is the most fluctuation with risk and interest. The default risk depends on how much profit and revenue a company will make in the future. If the probability that the company will make good profit is high, then the default risk will be low. But if their past revenue fluctuated and they have a history of not achieving their desired profit, then the default risk will be higher since there is a higher risk of the corporation not returning the full principal and interest. This means the interest rate will be higher. 

That is why it is crucial to do research about the company you are investing in beforehand. Depending on whether they have a reliable profit history or not, it will affect possible profit for the lender. That is why it is also important to assess the amount of risk you are willing to take while investing in a company, which directly correlates to how much interest you will gain.

Investing in Bonds:

Now that we have learned that municipal bonds and U.S. treasury bonds typically have lower risk than corporate bonds, let’s learn about when you should invest in bonds. It is typically a wise choice to invest in bonds since it brings diversity to your portfolio and is generally viewed as an investment option that has less risk. It is very important to remember that this is not always the case. 

All bonds have ratings which determine the default risk of a bond. The rankings are cataloged as Triple-A(AAA), AA, A, BBB, BB, B, CCC, CC, C, and D. With Triple-A being the highest ranking and D representing a bond that is in default. The higher the ranking of the bond, the lower the default risk. This means the corporation is more likely to pay the original price of the bond and interest back, which also means a lower interest rate. The ranking of a bond can help an investor assess the risk level of the bond, and whether it is an investment option for them. 

If you are a teenager who is looking to make a larger profit and is willing to face a loss, corporate bonds would be the best option. Especially companies that offer higher interest rates on their bonds. If you are looking for a safer option that will assure a low margin of loss then it would be best to invest in U.S. treasury bonds or municipal bonds. Despite the type of bond you are investing in, it is always crucial to determine what you are looking to gain out of investing. There are so many options with investing in bonds, but not every option is the right fit for every investor. 

Key Words We Learned About Bonds:

Default risk: The risk the lender faces in the situation the borrower is not able to return the borrowed sum. 

Debt-securities: It is a financial asset that is created when one party borrows money from another. It is essentially an agreement that the borrower will return the principal at a later time. Bonds are an example of debt-securities. 

Interest: Interest is the cost of borrowing money. When someone is lended money they not only have to pay the borrowed money back, but a certain percentage of the original price as a payment for borrowing the money. Interest is affected by the amount of money borrowed as well as the duration for which it was borrowed. 

Maturity: Maturity is the time period in which a financial asset will be terminated and the original principal plus interest will be paid to the lender. It also determines how much interest should be added to the original price of the bond

Risk: The degree of potential loss and investment decision could result in, for the investor.