Understanding Bonds

The name's bond. Fixed-rate bond. Cue dramatic music. OK, investment bonds may not be as glamorous as their 007 namesake, but they do play an important role, both for individuals and for governments and companies. For many people, however, there is a sense of mystery about them, which means that they are perhaps not employed as much as they could be, as part of an individual's portfolio of savings and investment funds.

What bonds mean for individuals

From the perspective of an individual, a bond is just a financial product that enables them to secure a fixed rate of return for a fixed period of time, provided that they are prepared to lock away a sum of money for the bond's duration. For example, you might see a five-year fixed-rate bond advertised that offers an interest rate of 5%. If you invest $1,000, you will be guaranteed to receive $50 per year (5% of $1,000) during the bond's five-year term. Often there is a minimum amount that investors have to lodge in order to benefit from a bond, and penalties may apply if they wish to withdraw some or all of their money before the end of the bond's term.

Where bonds sit in the savings and investment spectrum

Bonds occupy a space between standard savings accounts and shares in the portfolio of financial instruments. Standard savings accounts offer quick access to your cash, but often provide moderate returns. In contrast, shares offer the potential of high returns, but carry the risk that you could lose your money. Bonds generally require people to lock away their money for a set period of time, but in return, provide a higher rate of interest than would be found on most instant-access savings accounts. Additionally, the rate of interest is often fixed, providing the bond holder with the surety of knowing how much income they are going to generate.

The value of bonds to governments and companies

Governments and companies often need to raise additional money to fund expansion or various maintenance costs. One way of doing this is to raise a bond issue. Let's say that the government needs to raise ten million dollard ($10m) in funds. By issuing $10m worth of fixed-rate bonds, they can quickly obtain the required capital to fund their projects. Of course, an incentive is required to get people to buy into a bond, and this is where the interest rate comes in.

Who bonds appeal to

Bonds are attractive for many savers because they normally provide a reliable income stream. The value of shares may go up or down, but if you have a portion of your money in bonds, you know they will generate a steady return. People may switch some of their surplus money to bonds during times when the stock market is volatile or when instant access savings rates are low. Bonds will often be particularly attractive to pensioners, who need the security of knowing that they are going to get a reliable return.

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