A bond is a debt instrument issued by an investor to a governmental or corporate entity to finance its activities and projects. Bonds are commonly referred to as fixed income earning securities. A bond is similar to an IOU (I owe you) given by a borrower (the issuer) to a lender (the investor).
How Bonds Work
A corporate organization may require funds to construct new buildings. A municipal corporation may need to raise capital to construct a new hospital. These types of projects need to be backed by a huge sum of money. Issuing a bond is an economical way to arrange for such capital. The entity will issue a bond to the lender and agree to redeem the borrowed money with the stated interest when the bond matures. The issuer is in the position of a borrower of the loan. The return on that loan is the promise to repay the original principal with the interest when the bond matures.
While choosing a bond, the following factors need to be considered seriously: the bond's maturity, redemption features, credit ratings, interest rate, price, return, and tax status. There are different types of bonds including U.S. government securities, municipal bonds, corporate bonds, mortgage and asset backed securities, federal agency securities and foreign government bonds.
The diversity of these fixed income earning securities gives prospective investors an opportunity to customize investments in accordance with their financial objectives. Bonds ensure investment stability in times of volatile markets. They give steady and predictable payments and sometimes even tax-free income. Bonds offer high rate of return and are an extremely attractive investment alternative.
The price paid for a bond is based on a variety of variables including interest rates, supply and demand, credit quality, maturity, and tax status. Newly issued bonds buy and largely sell at or close to their face value. On the other hand, the price of bonds in the secondary market fluctuates in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount. The price of bonds are quoted as a percentage of the face (or par) value in newspapers and other publications. The expected rate of return may vary when an investor buys or sells an existing bond as he pays different prices at different points of time.
An investor can invest in bonds at every stage of his life. There are no hard and fast rules about when you should invest in bonds because an individual's investment strategy will change over time.
Most investors are likely to work with financial professionals for investing in bonds. These consultants are given different titles: financial advisors, brokers, sales representatives, stockbrokers, account executives, or registered representatives. They assume complete responsibility of managing the investor's personal wealth building strategy.