What Are Investment Bonds and How Do They Work?
Stocks and bonds are two of the most common types of investment products. While stock values change based on market trends, bonds appreciate at a fixed interest rate, offering more security though often with less lucrative gains. In a sense, stocks and bonds represent two different ways to balance risk against reward when investing.
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What Is an Investment Bond?
A “loan” is the shortest and simplest investment bond definition. A single investment bond is a small sliver of a massive loan. Numerous investors own the investment bonds that make up the whole of the loan amount to the borrower. Large corporations, city, or national governments usually use these loans to finance operations and projects. Therefore, the most common types of investment bonds are municipal and corporate bonds. Bonds usually share the same investment characteristics, such as the issue price, maturity date, and face value.
Types of Investment Bonds
There are many types of investment bonds sold on the bond market to investors. Some of the most common include:
- Corporate. These are investment bonds issued by either private or public corporations.
- Municipal. These bonds are issued by states, cities, counties, or other government entities and may include general obligation, revenue, or conduit bonds.
- High-yields. These are not investment-grade bonds and are therefore associated with higher risk, but also generally with higher interest rates.
- U.S. Treasuries. Investment bonds through the U.S. Department of the Treasury are issued on behalf of the government, so they are considered a safer investment.
Characteristics of Investment Bonds
There are specific characteristics associated with most investment bonds, including the following:
- Face value. The money amount the bond will be worth when it matures.
- Coupon rate. The interest rate the borrower will pay on the bond’s face value, usually expressed as a percentage.
- Coupon date. The date when the investor will receive the coupon payment, usually twice each year.
- Issue price. The original price at which the bond issuer sells the bond.
- Maturity date. The date when the bond matures and the issuer pays the holder the face value.
How Do Investment Bonds Work?
When a large company or entity needs to finance an operation or project, it may issue investment bonds directly. The bond includes details on the interest payments that will be made during the borrowing period and when the bond must be paid back, or its maturity date.
Investors can benefit from bonds because they are usually provided interest payments twice each year, and they are a good way to diversify investment portfolios. Borrowers can benefit because they obtain the lump sum of money needed to finance their projects or operations, or to pay off debt.
Many corporate bonds are publicly traded, while others remain private between the borrower and investor. While bonds and stocks are both commonly traded, it’s important to note the differences between the two investments. Stocks are shares of publicly-traded companies while bonds are fixed loans made to corporate companies or government entities. Bonds are not traded on the stock market but on the bond market, also referred to as the debt or credit market.
Who Issues Investment Bonds?
Investment bonds are issued by credit unions, public authorities, or companies when they need to borrow money to raise capital. Before being brought to market and offered to investors, investment bonds must go through an underwriting process.
The lead underwriter is referred to as the “book runner.” The book runner may confer with other underwriters or a group of underwriters, called the “underwriter syndicate.” Together, the underwriters purchase investment bonds and resell them directly to the market or to dealers, who will, in turn, sell them to investors.
Risks vs. Rewards of Investment Bonds
As with stocks, there are no guarantees on returns with investment bonds. A certain amount of risk is associated with all investments, including bonds. However, investment bonds are often considered less risky than stocks because you are guaranteed interest payments throughout the borrowing period. Long-term government investment bonds usually yield an average of 5% to 6%. Pros and cons include:
- You receive income through interest payments, usually twice per year.
- If you hold the bond until maturity, you’ll get your money back.
- Sometimes, you can resell the bond for more than you paid for it.
- You can package several bonds into a bond mutual fund.
- Investment bonds can be used to diversify your portfolio.
- Bonds may pay out a lower return on your investment than stocks long-term.
- Companies can default on investment bonds or fail to make interest payments.
- The higher the demand for bonds, the lower the return.
- A bond issuer may retire a bond before its maturity date.
- Changes in interest rates can affect the value of a bond.
Are Investment Bonds Safe?
In most cases, investment bonds are secured through insurance. This ensures the borrower must meet the terms of the agreement. However, keep in mind that insurance will not get involved if you simply lost money on your investment due to the terms you agreed upon when purchasing the bond.
Are Investment Bonds Taxed?
The income you generate from corporate and government bonds, including U.S. Treasury bonds, is susceptible to federal taxation. However, the interest you earn from municipal bonds is exempt from federal taxes. If you buy municipal bonds issued in your state, the interest you earn is also exempt from state taxes.
When deciding on the types of investment bonds to purchase, federal taxation shouldn’t be the only factor you consider. In some cases, the returns you receive on taxable bonds may be higher than on non-taxable investment bonds, even after paying the taxes you owe on interest.
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