Understanding investing terms can be challenging to new investors, who may wish to consider many types of investment accounts before determining which best suits their needs. The U.S. Securities and Exchange Commission (SEC) offers a website called Investor.gov, which offers an easy-to-understand introduction to the various types of debts and investments. As we'll learn, bonds are a type of debt wherein the borrower (or debtor) agrees to pay back a certain amount of money to the investor (or creditor) after a certain amount of time.
Bond Debt and Other Types of Debt
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According to the team at Cornell University's Legal Information Institute, debt can be defined as a financial obligation that is held by one entity; they are known as the debtor. The debt is owed to another entity, the creditor. Debt can be secured or unsecured, which refers to whether the debtor has pledged assets or property to ensure that the debt will be repaid. Recourse debt allows the creditor to pursue the debtor's personal assets to repay the debt, and nonrecourse debt does not.
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Types of debt include promissory notes, mortgages, credit card balances, debenture and bonds, the latter of which we'll discuss in more detail below. A promissory note, or note payable, is a written promise to pay a certain amount to a specific payee at a specific time.
A mortgage is a debt incurred in the purchase of property, while a credit card balance is money owed to a credit card company based on purchases made on the credit card account. Many consumers have both of these types of debt. A debenture is an unsecured loan instrument, such as a bond. Because debentures are unsecured by collateral, the investor's only guarantee of repayment is the trustworthiness of the issuing institution. Many consumers also have bonds that they have purchased through the government.
How Do Bonds Work?
Bonds are a type of debt security, or tradable debt, typically issued by a corporation or government entity. The issuer pays regular interest over the life of the loan and pays out the principal when the bond reaches the end of its term, or matures. Federal, state and municipal governments issue bonds in order to get cash flow for operating expenses or to fund major capital investments such as the construction of highways or schools.
A bond can be a smart type of investment exactly because it carries a relatively low risk and a likely stable payout. Not only does the bond issuer pay interest on the bond (usually twice annually), but when the bond reaches maturity, the issuer pays back the bond's full principal. Bonds are a recommended part of a stable retirement portfolio, depending on how close you are to retirement. A financial advisor can help you decide which percentage of your portfolio should be in bonds at any given point in your financial journey.
When the issuer is a government entity, the investor can feel confident that they will be repaid in full. Moreover, the interest payments on many types of government bonds are exempt from federal income tax and may be exempt from certain state and local taxes too.
Types of Bonds
Writers at Investor.gov lay out the major types of bonds and how they all work. Investment-grade bonds have a higher credit rating, as compared to high-yield bonds, which carry a greater credit risk while offering higher interest rates.
Municipal bonds, or munis, are those issued by government entities at the state, city or county level. Perhaps most secure of all are U.S. Treasuries, which are bonds backed by the full faith of the United States government and therefore considered to be quite secure investments.
Consider also: Difference Between Stocks & Bonds