OK, ladies. I’m gonna let you know how bonds work but first, I need to put it into context for you.
To start, think about buying a home, going to college, purchasing a car. You know, the BIG stuff.
I don’t know about you, but it’s not very often that I have an extra couple hundred thousand dollars or so lying around to cover the up front cost of these things.
So, when you don’t have enough money to buy a brand new car or start that new degree, you might ask a bank (or even a friend or family member) for a loan.
The government and big companies are not immune to the occasional need to borrow money. If we’re being honest, sometimes they need the money more than we do.
We all know it’s never fun to ask for money, especially if you have to prove to a bank that you even deserve a loan.
That’s why big businesses and government organizations came up with a somewhat sneaky way to borrow money without seeming like they’re borrowing money.
While it would be hilarious to watch the government awkwardly ask their dad for a small loan, this low-key borrowing method actually makes for a great investment opportunity: the bond.
You know when people say “stocks and bonds”? Yeah, that’s the bond part we’re talking about.
So, what is a bond exactly?
A bond is a type of investment for purchase, just like a stock. A bond is different from a stock in how it functions.
When we buy a stock, we’re buying an ownership interest in the company and we get paid back when we sell the stock after it (hopefully) has increased in value.
But here’s how bonds work.
When we buy a bond, we’re lending someone (the government or a company) money. In return, we get our money back plus interest.
A bond is known as a fixed income investment because there is an agreed upon interest rate. It doesn’t fluctuate after you enter the agreement. In other words, you — the investor — get back a fixed amount.
Companies turn to bonds when they are looking to borrow a larger amount of money than a bank can provide. They can instead sell shares of stock or bonds to raise money and anyone who wants to can buy them.
Let’s say that a company decides they’re going to expand to another country and they need $70 million to accomplish the job.
They can decide to issue (sell) bonds at $1,000 per bond and an interest rate of 5%. The interest rate is known as a coupon rate.
At $1,000 per bond, the company will need to sell 70,000 bonds to reach their $70 million goal.
Eventually, the company will be expected to pay those bonds back.
This happens when the bond reaches its maturity date — the due date of the loan. When the bond hits the maturity date, the company is responsible for paying out their loan to everyone who purchased a bond.
If the maturity date isn’t for ten years, each bond holder will earn 5% interest on their $1,000 investment ($50 per year) for that entire length of time.
Then, after ten years, the company will pay investors back their $1,000.
So, in short, when you invest $1,000 at 5% interest per year, you walk away with an extra $500, for a total of $1,500. You didn’t lose your $1,000 — you just lent it, got it back, and gained some interest. As if you are running your own tiny bank! Dang, look at you making money like a fancy financier!
Ok, now you know how bonds work so you’re probably wondering…
What’s the catch?
The greatest risk is just the faith you place in the company. The bond system assumes that the company you lend money to will make on-time payments and pay all their bondholders back. This doesn’t always happen, as you can imagine.
If companies are unable to make their interest payments or pay back the original value of the bond, the bond goes into default.
If this happens, the company will liquidate its assets and distribute money to anyone they owe — including you, if you bought a bond.
How much you get back (some or all of the cost of the bond) depends on how many assets the company has to distribute and how many creditors the company has to pay back.
If your bond isn’t very high up in their hierarchy of who to pay back, they may run out of money before they get to you. It doesn’t happen often, but this is one of the primary ways you might lose money on a bond.
Despite this, bonds are considered an extremely safe investment. Your interest rate is fixed so you don’t have to worry about fluctuating market conditions as much as you do with stocks.
As with most investments, timing is key. If interest rates suddenly go up to 8% after you’ve purchased a bond with a 5% interest rate, well then, you missed out on buying a bond with a higher rate of return which would net you more money in the long run.
On the flip side of that (the side that benefits you), if interest rates suddenly drop, your bond is now more valuable because it has a higher interest rate than the current rates.
How can you get started investing in bonds?
If you’re totally sold, the best way to get started is to use the Infinite Income method to start investing in baby bonds.
Baby bonds are low cost bonds that you can buy and sell just like a stock. Baby bonds have a face value of less than $1,000, which allows “ordinary” investors (no offense – we think you’re super special) to purchase bonds without having to invest a ton of money.
Low cost, low risk, stable return. The perfect combo.
And that, my friend, is how bonds work.
So, if you’re tired of always being the one who’s doing the borrowing, maybe it’s time to do some lending of your own.
Cause then you could say things at brunch like, “the government is calling to borrow money again? Ugh, okay, just this once.”