Students with a small amount of savings on the side might want to consider putting their nest egg in secure investments so that it grows over time. A savings account from a bank will hardly accrue any interest, and a CD will often yield little more. The obvious choices left are stocks and bonds, two of the most common investments available in the U.S. financial market. Today I’d like to do a brief overview of bonds, which are often typecast as safer and relatively less profitable than stocks. I’ll explain how that isn’t necessarily true and how you can stand to reap high yields from smart bond purchases.
So how do you explain bonds to a college student?
Investing in Bonds
It’s a bit cliché, but it’s true: buying a bond is really like getting a huge IOU from a company or the government. The companies or government takes your money and invests it in current programs or projects that need funding. Theoretically, the profits of those endeavors will go to pay you once it’s time to pay up. To invest in a bond you give a certain amount of money to a bank, broker, or the U.S. Treasury (if you’re buying government bonds) and they issue a paper copy of a bond that details what amount you will be owed upon its maturity date.
If you hold a bond until maturity, then you get your initial investment back plus the interest on the bond. Interest will vary depending on the size of your initial investment, the set maturity date, and the type of bond that you take out. Some bonds adjust their interest rates according to inflation (like I bonds) while most have a fixed interest rate. Interest can be paid monthly, quarterly, semi-annually, or annually depending on the terms of the original bond.
Investing in Government Bonds
If you’ve purchased certain government bonds (like Savings Bonds), you can’t touch the money you’ve invested in them for a set period of time, otherwise you will have a penalty for early withdrawal. It’s important that you realize the long term nature of Savings bonds. If you’re looking for a quick way to make money, savings bonds are not the way to go. On the other hand, if you want a relatively secure long term investment, then bonds may be a great fit.
Other Treasury obligations like T-Bonds and T-Bills and private obligations like Corporate bonds are much more liquid since you can sell them on the secondary market which means that although you can’t get your money back from the original issuer you can sell them to another investor.
Long term bonds from the U.S. Treasury are considered low risk. The market assumes there’s little chance that the U.S. government won’t redeem their loans, since they can always print enough Dollars to cover their debts. On the other hand, you won’t get a high interest rate on government bonds. You still face the risk of being paid back with money that has depreciated due to inflation and thus purchases less than what you initially invested.
Investing in Corporate Bonds
Corporate bonds have a better chance of earning you a higher return on your investment in the long run and they are backed by the value of the company. In the event of Corporate bankruptcy, bondholders are creditors and are thus guaranteed to be paid back before stockholders receive a penny. By contractual agreement bond investors are guaranteed to receive the full value plus interest if they hold their bonds until maturity. But if they are sold before maturity on the open market you could receive more or less than the face value of your bond depending on the relationship between the prevailing interest rates at the creation of the bond and the current prevailing interest rate. If the prevailing interest rate has fallen the bond will be worth more (because it has locked in the earlier rate) thus this bond would be selling at a “premium”
If the prevailing rate has risen the bond will be worth less than “Face Value” and it will sell at a “discount”. The old saying is “Interest up – Bonds Down, Interest Down – Bonds Up”.
Choosing the Bond Duration to Invest In
The shorter the time until maturity of the bond the safer the bond is and the closer it will trade to “Face value”. Because bonds can be purchased on the open market you can buy a bond the day before it matures, so you can easily choose the length of maturity you would like, whether it is one month, one year or 20 years you can find bonds of the duration of your choice. A bond with a one year duration until maturity will be subject to less risk due to fluctuation in interest rates and loss of purchasing power. You will also be better able to judge the ability of a company to repay its debts.
About the Author:
Angelita Williams is an education blogger who loves writing about all the latest online learning trends in the industry. When she’s not writing articles, Angelita is probably trying a recipe from her library of cookbooks.
See Also:
Invest in Inflation Indexed Bonds
Certificates of Deposit (CD) Rates
