When you take out a loan for any reason, you as the borrower are charged interest. If you take out a personal loan for $1000, and if the interest on that loan is 10%, then you will be charged $100 in interest (10% of $1000). The total cost to you for borrowing that money is now $1100. A bond is the same thing, only now, you are the bank and the government is the borrower.
Everyone from time to time needs a little extra cash; the government is no different. In fact, as we all know, the government needs it ALL the time (that’s a separate topic for a separate blog post, lol). When the government issues bonds (also called a debt security), usually in $1000 increments, you can purchase those bonds with the promise of interest payments for your troubles. WOW! You mean the government is going to give me money instead of take my money? Cool!
Corporations also issue bonds, but that is also a separate topic for another blog post, as those are a LOT more risky. U.S. government issued bonds are said to be the safest investment in the world, as they are backed by our government which, in essence, has an ‘A’ rating in terms of credit worthiness. Lol, we could probably make joke after joke after joke about this, but it’s true.
There are quite a few terms in the bond investing world. Let’s talk about them…
Types of bonds:
- Treasury bill (T-bill) – These are short term debt securities with maturity dates less than 1 year. These pay you back via what is called a ‘discount from par’. Basically, the discount from par is the interest. If they want $1000, and the discount is $950, then you give them $950 and on maturity date they pay you $1000. The difference between what you paid and what they gave you, in effect, is the interest.
- Treasury note – These are debt securities that have a fixed interest, with maturities between 1 and 10 years. Currently, the 10 year treasury note is yielding just under 3%
- Treasury bond (T-bond) – These are also fixed interest, but have maturity dates of 10 years or more. These bonds make payments to you semi-annually and the money you make is only taxed at the federal level.
There is a whole section of investors that only trade bonds. As with any other form of investment, bonds also carry inherent risks specific to them… if you trade them. If you do not actively trade them, and simply hold until maturity while collecting your interest payments the whole time, then these are said to be virtually risk-free. However, I am very cautious when I invest in anything, so I still would approach a bond assuming there is some level of risk.
This was a crash course in the bond market. There are many more terms to know when investing in bonds; I will blog about them in another post.
As always, thanks for reading, and any feedback is much appreciated!