How Do Bonds Generate Income for Investors
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We are all at least familiar with the concept of borrowing money. On a large scale, most of us have had to do it when buying a home or a car. It is likely we’ve all borrowed money from a friend on a smaller scale, as well.
With that said, municipalities and companies do the same. The federal government even does it. The method by which the government does it is through bonds. So, how do bonds generate income for investors?
We will take a good look at investing in bonds so that you can decide if they belong in your personal portfolio.
What Are Bonds?
Bonds are a type of investment that falls within the category of fixed-income securities. That kind of security is a debt obligation. This means that one party is essentially borrowing money from another. The expectation is that it will be paid back with interest.
There are several varieties of bonds. There are government bonds, municipal bonds, and corporate bonds. They differ really only slightly. The concept is the same with all of them, which is that they function as a debt instrument that can be used to raise capital.
In exchange for the bond issuance, the issuing entity requests an investment amount. In exchange, the issuer pays that investment back, along with interest, over a specific time period.
How Do Bonds Work?
The concept is quite straightforward. When you purchase a bond, you are loaning that sum of money to the issuer of the bond. That loan is set for a specific period. In exchange for that loan, the loan issuer makes a promise to make regular interest payments until the bond is due. It then repays the principal when the bond matures.
There are exceptions related to how bonds work. One of these is the zero-coupon bond. With this particular investment, you do not receive any interest. However, these bonds are sold below their face value.
In general, most bonds do follow the same formula. That is, the investor invests a particular amount of money, is paid interest payments on that investment, and then gets all of the money back when the bond matures.
Types of Bonds
As mentioned earlier, there are different types of bonds. Each of them has its own advantages and disadvantages for the investor.
1. Municipal Bonds
These bonds can also be referred to as muni bonds. They are issued by cities, localities, and states, and they are used to finance public services and projects. As an example, a city might issue municipal bonds to construct a bridge or create a public park.
There are two kinds of municipal bonds: revenue and general obligation. General obligation bonds are backed by the issuer’s credit. This means that if a city issues these types of bonds, it can sell assets or take other steps to repay the bondholders according to the schedule set by the bond.
Revenue bonds are supported by streams of income that are tied to the bond. For example, if a city issues this type of bond to build something, such as a toll road, the proceeds from that toll could be used to repay the holders of the bonds.
Both kinds of municipal bonds pay interest that is not subject to federal taxes. If you purchase municipal bonds that are issued by the state in which you live, you also can avoid paying local and state taxes.
Taking that into account, it is worth mentioning that the interest paid on municipal bonds is usually lower than what you would receive from corporate bonds that have a similar rate.
2. Corporate Bonds
As you could safely assume by its name, these bonds are issued by corporations. They are done so to raise capital for operations that are related to business ventures. For example, those operations could be expansion, product development, or research.
These bonds usually offer a higher interest rate than other kinds of bonds. Aside from being high, that interest is taxable both at the federal and state level.
3. Treasury Bonds
These types of bonds can also be referred to as T-bonds. They are issued by the United States government. Any interest received from treasury bonds is subject to federal taxes. However, these bonds are exempt from local and state taxes.
A treasury bond has a maturity that is at least 10 years or longer. Because it backed by the United States government, most investors think of treasury bonds as pretty risk-free. With that said, they do not offer interest rates that are as high as what you can expect from a corporate bond.
How Do Bonds Generate Income for Investors?
There are two primary ways that investors can make money on bonds. The first way is by receiving interest payments. This is known as the coupon. Those payments are received for the full lifetime of the bond.
So, for example, if you purchased a $1000 10-year bond that had a coupon rate of 8%, you would receive an interest payment of 80 dollars each year. This is known as the coupon. The majority of bonds pay twice per year. So, in the above scenario, you would get paid twice a year for 40 dollars each time.
The second way in which you can make money is through the fluctuation in price. This is similar to how any other kind of security works. That price fluctuation varies based on several factors.
The most crucial of these factors is the market’s current interest rate. Many investors will try to make money based solely on the price changes of the bond. They do so by guessing how the interest rates will change.
Making Money From Zero-Coupon Bond
To make money from a zero-coupon bond, interest is paid based on maturity. So, exactly how do bonds generate income for investors using a zero-coupon bond?
A zero-coupon bond can also be referred to as a discount bond. It is purchased for a specific amount that is lower than the current face value. This means that when the bond reaches maturity, the full face value is paid.
The entity that initially issued the bond does not make any interest payments, otherwise known as coupon. However, it does pay the entire face value when the bond finally reaches maturity. A well-known example of a zero-coupon bond is savings bonds issued by the United States Treasury.
The majority of these bonds pay just a set amount of money, equal to their face value. However, some are also linked to inflation. In this instance, the amount repaid to the holder of the bond is determined based on the actual amount of the purchasing power rather than the actual dollar amount.
Zero-Coupon Bond: Reaching Maturity
A zero-coupon bond takes time to reach maturity. The length of that time depends on whether it is a long-term or short-term investment.
A long-term investment will usually have a maturity date that starts sometime around 10 to 15 years. A short-term investment, on the other hand, will have a maturity that is no longer than one year. These are usually referred to as bills.
The Zero-Coupon Bond: Who Benefits the Most?
Zero-coupon bonds do not make any interest payments to the bondholder while the bond is maturing. This means that the bondholder could wait several years or even close to two decades before any profit is made.
This means that a zero-coupon bond may not be the ideal investment choice for someone who is retired and looking to make a regular income from their investments. That steady stream of income can lead to financial freedom in retirement years.
While the zero-coupon bond might not be ideal for a retiree, it may make a great option for a family that is looking to save for a big future purchase. For example, a family may be working toward purchasing a vacation home. A zero-coupon bond that has a 15- or 20-year maturity period might be a great option.
This investment might also be a good option for someone who wants to leave behind an inheritance to their loved ones. If a $2,000 bond is gifted to a loved one, the person who gives it only has to use $2,000 of their gift tax exclusion for that year. The person who receives the bond will get more than the initial investment of $2,000 when the bond finally matures.
For tax reasons, zero-coupon bonds that are issued in the United States maintain their original issue discount. Those bonds usually input receipt of interest payments, otherwise known as phantom income, even though the bonds don’t actually pay interest periodically.
Because of this, zero-income bonds that are subjected to taxation in the United States are allowed to be held in a tax-deferred retirement account. This essentially allows investors to avoid paying taxes on income that won’t be received for years to come.
There is also an alternative to this. If there is an issuance of a zero-coupon bond by a United States state or local government entity, the interest that is imputed is free from federal taxation. It is also usually exempt from local and state taxes also.
How to Buy Bonds
If you have long-term goals that you are trying to reach, using a financial advisor is usually advisable, especially given the sometimes complicated nature of retirement savings and investments.
Stocks are easy to buy and sell since they are traded publicly. However, bonds are not. Instead, they are traded through brokers. The exception to this is a treasury bond, which can be bought directly from the United States government.
The challenge with this process is that it can be very difficult for investors to know if they are paying a fair price for their bonds. For example, a broker may sell a particular bond at a high price, above its face value. Another broker might charge an even higher price.
To help mitigate some of this, the Financial Industry Regulatory Authority does regulate the bond market to some degree. It does so by posting the prices of transactions when the date is available.
However, investors may experience a lag time when trying to get that information. This shouldn’t necessarily deter you from purchasing bonds, but it is something you should keep in mind.
In general, bonds are considered to be low risk when compared to investing in stocks. With that said, they are not without any risk. It doesn’t take much to lose your money. You can lose your investment if the bond defaults.
With that understood, how can you know which issuers are the most reliable? The best way to know is to check the ratings of the bonds.
The bond rating is a kind of score. It is used to measure the overall financial strength of the bond issuer. There are three primary agencies that release bond ratings. They are Fitchm, Standard & Poor’s, and Moody’s. Each of these three agencies uses a combination of numbers, symbols, and letters to indicate the overall creditworthiness of the issuers.
Several bonds are not actually held until their maturity period ends. If you find that you need your money back before the bond matures, you have the option of selling the bond through a broker.
If you decide to do this, you may earn a capital gain, or you might experience a capital loss. It depends on what has happened to the issuer’s credit quality.
For example, if the entity that sold the bond to use was originally healthy but has since filed for bankruptcy, you should expect to receive pennies on the dollar. This is because other investors in bonds are not going to want to take any chances unless they can get a high rate of return.
If interest rates have gone up, your bond likely lost value, given that investors will demand a higher return on the rate of the coupon. The opposite is also true. If the bond rates plummet, you can sell your bond for a higher price. This would result in a capital gain.
Other Ways to Earn Money
Using bonds to generate income is a viable way to make money. There are other ways to earn money, though. Some require very little effort on your part.
For example, in just three simple steps, you can use Twitter to make money from home. You don’t need to have a twitter account already. In fact, you don’t even need to know how to use it. The program is easy to follow, and you can learn it in nearly no time at all. While bonds can sometimes get a bit confusing, this program is easy and straightforward.
Bonds are not truly that complicated once you get the hang of investing in them. If you were initially wondering how do bonds generate income for investors; hopefully, you now have an idea of how bonds can truly build your portfolio.