What is Bond – MoneyPerception

What is bond? Bond is a financial tool for governments and businesses to borrow money. When you invest in a bond, you lend your money to the organization who issues the bond. The bond issuer should promise to pay your money back after certain period. The bond issuer should also offer you additional money as an interest for the borrowing.

Why do we need bonds?

Obviously bond isn’t the only way to borrow money. If you, as an individual, want to borrow money, you may go to a bank and sign a loan agreement. So why do we need bond? It turns out bond issuer usually needs a large amount of money from lots of investors. It will be very time-consuming and complicated to sign agreements with thousands of, sometimes tens of thousands of, lenders. So governments and companies issue bonds. If you are willing to lend money to them, you can just buy the bonds they issue.

Example of bond

Suppose McDonald’s Corp. wants to borrow $1 billion for 3 years, they can issue 10 million bonds. Each bond represents $100 borrowing. So you will need to pay them $100 to get a bond. They should promise that they will pay you back $100 at the end of 3 years. They may also pay you $5 as an interest at the end of each year during the 3-year borrowing period. So the interest rate is $5/$100= 5%. When the article is written, the 5% interest rate of bond is higher than the money you will get if you leave your money at a bank. So it may be a good deal. However, there is a risk here. If the bond issuer bankrupts, you may not get your money back. The conclusion is you need to do some research before investing in a bond.

The risk to invest in a bond

Some people mistakenly think bond is always a “safe” investment. While a specific bond may be less risky than another specific investment, investing in a bond also has its risks. There are mainly two types of risks to buy bonds. First, the bond issuer may bankrupt or default. In that case, you may lose both interest and your initial investment. Second, when you invest in a long term bond, you may have to deal with another type of risk, the interest risk. For example, if you invest $3000 at 30-year IBM bond in 2010, with an interest rate of 5%. After 5 years, in 2015, for some reasons you want to sell it. Suppose the government increases the interest rate in 2015 and similar bonds offers 10% interest rate. It will be difficult for you to find a buyer, because if investors can get a 10% bond at the market, why do they want to buy the bond from you with only 5% interest rate? The only logical way for you to make it happen is to lower your selling price. So you won’t be able to sell your bond at $3000, the price you get it. You have to lower your selling price significantly lower. During this process, you may incur a loss for your bond investment.

How to invest in a bond

You can invest in bonds by purchasing individual bond or bond mutual fund. If you choose to invest in an individual bond, you can open an online brokerage account, or call a traditional broker. When you invest in a bond mutual fund, you don’t need to pick individual bond. Essentially you give the money to the manager of the fund, and he will manage the bond investment for you.

So to invest in a bond mutual fund, you save time and effort on picking a bond. However, you still need to pick the right bond fund!