How Bonds Work

One of the most important principles of investing is that of diversification. This merely means that a prudent person should protect their money by investing in various kinds of investments. Bonds are an investment vehicle that have a place in every investment portfolio. Bonds provide a stability and guarantee of return that offsets the risk associated with other types of investments. Before you begin investing in bonds, it is important to understand how bonds work.

Bonds are merely the means that corporations or governments use to raise money. A corporation, for example, might want to raise money to build a new factory. Rather than borrow money from a bank or issue shares of stock, the corporation can issue bonds to generate the money. An investor lends the corporation his money and receives a bond for that amount in return. The bond is actually an IOU from the corporation.

The investor is paid a specified amount of interest on a regular schedule until the bond matures after a specified number of years called the bond's term. At that time, the total amount loaned to the corporation is repaid to the investor. Some bonds pay all of the interest at one time when the bond matures. However the interest is paid, the exact details of the payment of interest and repayment of the loan amount are specified within the bond. This guarantee provides the investor with protection from the fluctuations associated with some other investments.

There are several different ways you can begin investing in bonds. Savings bonds issued by the United States government can be purchased online or at any bank or credit union. You can find plenty of government, tax free bonds online. US Treasury bonds and notes can be purchased through their website. Federal, state and local government agencies issue bonds that can be purchased through a stockbroker. Corporate bonds can be purchased through a stockbroker or sometimes directly through the issuing company.

Bonds can also be purchased indirectly by investing in mutual funds that specialize in trading bonds. These mutual funds purchase bonds of varying return, maturity and credit rating. This method of investing in bonds means the individual does not have to choose individual bonds in which to invest. The fund company manages the bonds and the investor is paid based on the performance of the bond fund as a whole.

The safety and guarantee of performance is an important result of how bonds work. For example, stocks are a much more volatile investment. A share of stock represents a portion of a corporation owned by the investor. The value of the share of stock rises and falls in response to changes in interest rates, profitability of the corporation and the economy in general. A bond issued by the same corporation would return the guaranteed amount in all economic situations. For this reason, bonds have a place in all investment portfolios to provide security and protection of capital.