Bonds are signed documents that recognize a debt relationship in which corporations or governments are the debtors. They borrow money either to grow as a business or to pay for public works. To investors who buy the bonds, they promise to pay earnings at a predetermined rate at regular intervals over the bond’s maturity period. When that period ends, the bond issuer is obligated to return the principal borrowed. Bonds are available as short-, medium- and long-term investments.
The Three Bonds
Short-term bonds mature in one to three years. Medium-term -- sometimes called intermediate-term -- bonds take four to 10 years to return your principal. Notes that take longer than 10 years to reach maturity are classified as long-term bonds. According to the Kiplinger website, long-term bonds can require up to a 40-year commitment, but their investors are rewarded with the highest earnings of all bond categories.
Companies and governments have the option to issue what is known as a “callable bond.” The prospectus for those discloses that the debtor is allowed to recall the bond before it reaches maturity. By repaying the principal early, the bond issuer reduces the amount of interest he owes the creditor. Often, callable bonds set a minimum period during which they must be allowed to mature before being recalled, thus guaranteeing the investor some earnings.
Pros and Cons
The pros and cons of short-term bonds have to do with how much risk you are willing and financially able to take. According to CNN Money, a 30-year Treasury bond returns 1 to 2 percentage points more interest than a five-year Treasury note, for example. But short-term bonds are the safest. They are not as susceptible to unpredicted changes in the economy, far in the future, that might cause the bond’s predetermined yield to lose value because of high inflation. If you need guaranteed earnings or if you have plans to use your investment capital in the near future, a short-term bond seems to be your best option. If you are not 100 percent clear on which bond type has the greatest potential to meet your investment goals, consult a financial adviser before committing your cash.
According to the website Market Watch, the cost of investing in bonds is higher than the fees for trading stocks. And because they are loan agreements, bonds in general also carry the risk of default if the borrower cannot pay the promised interest or return the principal. Secured bonds are available, and they offer a collateral if the bond issuer fails to fulfill its financial obligations. Bond insurance also exists to protect investors against default, but the cost of the policy cuts into the earnings.
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