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What Are Bonds, and How Do They Work?

Financial advisers are fond of advising people to invest in bonds on the belief they are reliable investments that add a layer of stability to an investment portfolio. While people rely on loans to buy things they can’t afford, companies businesses as well as governments turn to bonds. You might also have heard of a business or a government issuing a bond. So what are bonds?

What Are Bonds?

Simply put, bonds are fixed-income instruments that act as loans issued by an issuer with a view of raising a significant amount of money.  Governments, corporations, cities, as well as businesses, rely on bonds to raise money. A bond acts as a massive piece of loan that requires the issuer to borrow money from more than one source that, in this case, act as investors.

How Bonds work

The borrower, which in this case is the bond issuer, will quote the amount they wish to raise from the market. The issuer will also quote terms of the bond or loan as well as interest payments that investors will get and the time within which the loan will be paid.

The interest payment, in this case, acts as the return that bondholders get to earn for loaning money to the bond issuer. The interest rate is often quoted as the coupon rate. Investors are, in this case, are given an opportunity to loan any amount they wish to the issuer and in return get to enjoy interest payments over the duration of the bond.

Once the bond matures, the issuer must return the principal called the face value, to the investors. Likewise, an investor gets to walk away with the principal in addition to interest payment paid throughout the duration

A bondholder does not have to hold the bond through to its maturity date. One can decide to sell the bond to other investors. Likewise, the issuer can decide to buy back the bond should interest rate decline or should its credit improve.

Read More: What Causes Stock Market Fluctuations

Advantages of Bonds

Bonds provide an opportunity for investors to earn interest payments until bond maturity. Upon maturity, one gets to walk away with the principal in addition to the interest payments.

You can also resell bonds at a higher price than you bought it, to another investor.

Disadvantages

Compared to other investments, bonds tend to pay lower returns over the long run. Bonds return, especially with fixed interest rates, might not be enough to outpace inflation.

Companies can also default on bonds.

Ruchi Gupta

Ruchi Gupta covers various beats from finance to technology and from lifestyle to hobbies. She has an MBA in Finance. Ruchi enjoys writing on celebrities and political news. She likes traveling and exploring places.

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