What to Invest in, Part II—Bonds
Episode #4 of the course Investing money for beginners by Maureen McGuinness
In Lesson 3, we looked at one part of the stock market where an investor can purchase a stock in a company. By doing so, they would not only potentially gain from any growth in the price of the stock over time but also receive regular income from dividends. Another way of investing through the stock market is by purchasing bonds.
Bonds
When an investor purchases a bond, they lend money to a company over an agreed period of time and for a fixed or variable interest rate (referred to in this context as the coupon rate). A bond is like an IOU and is commonly referred to as a debt investment or a fixed-income security.
When companies need to raise money to fund expansions or other projects, they will sometimes issue bonds to investors instead of taking a loan from a bank. Initially, the company will issue bonds for a fixed period (offer period). After this period, you can still invest in bonds via the relevant stock exchange, but the price you pay will depend on the markets at the time you invest, i.e. you won’t be able to buy the bond at the same price that the initial bond investors paid for it. The price you pay may be less (below par) or more (above par) and is dependent on the appetite at that time for the interest rate it pays.
Why might you choose to invest in bonds over stocks for a particular company? If a company goes bankrupt, there is a hierarchy of how any remaining money from assets is distributed. When you are a stockholder, you have an equity stake in the company, whereas bondholders have a creditor stake in the company. Creditors have priority over stockholders in the payment hierarchy, meaning your money could be safer when held in a bond. As a stockholder, though, you can hold your stake indefinitely and you may gain a higher return if the company performs especially well.
Bonds can be held until maturity, which is usually determined at the outset (five years, ten years, or more). You can sell your bond early, but you’re not guaranteed to get its face value (the amount you paid for it at the outset). The price you’ll get depends on the demand for the interest rate offered by the bond.
Like stocks, you can invest in a bond through an index fund or ETF.
Ethical Bonds
An ethical bond is a bond that does not help raise capital for companies in the tobacco, gambling, arms, and alcohol industries and any environmentally-unfriendly companies. You lend your money as you do any other bond for a set period and for an agreed rate of interest. This is one way to invest your money for organizations supporting local communities or helping tackle the world’s biggest problems, e.g. climate change and poverty.
These types of bonds are usually held for a long time (20-25 years) before the capital is returned, but you may receive an interest payment quarterly or twice a year, depending on the type of bond. If you’re in the UK, you can see what’s available through Ethex (unfortunately, there isn’t any equivalent for investors in the US). As you can tell by the maturity dates offered, you should only tie up money in this type of investment that you won’t need for at least 20 years. Some schemes do pay back your capital partially before the maturity date, but this isn’t guaranteed.
These are two common ways to buy debt investments, but in recent years, investors can purchase debt investments through another service, peer-to-peer lending, which we will cover in tomorrow’s lesson.
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