Here’s what you need to know about the pros and cons of bond ETFs.
What is a bond?
A bond is a financial instrument used to raise funds for the issuer by placing the issuer in the bondholders’ debt. They are used by both corporations and government agencies to generate funds by essentially borrowing money from bondholders, which is paid back when the bond matures. In return, the bondholder enjoys interest payments on the bond’s principal.
Bondholders lend money to the institution that issues it. In return, the institution pays periodic interest payments to the bondholder for the term of the loan, called the coupon rate, and pays back the bond in its entirety at the time of its maturation. A credit rating is used to determine the interest rate, with a lower credit rating indicating a higher risk of default.
Bonds are fixed-income securities, meaning that the amount of revenue generated each year is “fixed” when the bond is sold: the bond generates exactly the same amount of money, regardless of what happens or who holds the bond. Buying bonds helps investors diversify their portfolios.
One of the most common types of bonds is the municipal bond, which is issued by local governments to pay for public services like building roads or schools. They have much higher interest rates that other financial instruments like savings accounts or CDs, but they also require a much higher initial investment. The U.S. federal government also sells bonds, which, in addition to paying for public services, are used to fight inflation. These bonds are unsecured, meaning they’re not backed by collateral.
Corporate bonds are the other most common type. They resemble stocks in that they allow people to invest in a company and receive a return on their investment, but they don’t offer the same ownership in a company. Corporate bonds guarantee holders a return, while stockholders aren’t guaranteed anything, but they have a lower return on investment over time. While they also have a higher risk of default, they’re secured by the company’s funds should it go bankrupt. Some corporate bonds can be converted into stock, netting the holder a strong equity position should the company make a profit.
While you decide whether a bond a right for you, you might consider opening up a CD instead.
Daniel and Craig inherit their father’s spy equipment emporium, James & Sons, which is beloved in their little London community. When they take a look at the company’s books, they realize they’re in the red and need to raise money for the company. As a privately held company, they can’t issue stock, so they decide to sell bonds with a one-year maturation and decent coupon rate. Each James bond costs $1,000, and many in the community pick them up, securing a lot of cash for the brothers to continue operations and expand the business.