When my brothers and I were kids, our mum decided it would be a good lesson in finance to give us all 5 year government bonds for our birthdays (luckily we also got something a little less sensible to keep us happy). This actually went on for a number of years and we ended up with a few hundred dollars each in bonds. Naturally I tossed my bond certificates in a bedroom cupboard and didn’t give them any further thought…. until I got a notice of maturation.
Government bonds don’t differ too much from any other type of bonds really, but I’ve noticed that you don’t really hear that much about them. I guess they aren’t particularly sexy, but there are some good opportunities in using fixed rate bonds over the long term.
How government bonds work
Bonds are often used as a revenue raising alternative by entities that don’t want, or can’t have shareholders. State or local governments, large corporates and credit institutions are the most common.
Government bonds are essentially a certificate or bond coupon that states the amount an individual has contributed, with a promise to return this within a fixed period of time under a guaranteed rate of return (which is why they are also referred to as fixed-income securities).
If you purchased a 10 year bond for $5,000, with a return of 8 percent. You would earn $400 ($5,000 x 0.08) in interest every year for the next 10 years (or $4000 in total). After the 10 year period, you would also get your $5,000 back. [/box]
If you aren’t too sure about how to calculate a rate of return, you should check out my article on how percentages work.
How bonds differ to shares and term deposits
when you purchase bonds you become a creditor to the business, which means that they owe you the money you lent them and are obligated to repay it (with interest). The reason why they are generally considered safe is because you would get paid before a shareholder if the business goes bankrupt, although there is still an element of risk.
Shares are different to bonds, because you are actually buying a piece of the business rather than just lending them money. This might result in voting rights, or other decision making abilities, which you don’t have with bonds. Share holders might be paid a dividend, but the real return genrally comes when your share grows in value as the business grows. A bond does not enable growth, but while you do not share in any profits, in most cases you also don’t suffer any losses (reductions in share value).
On the surface term deposits look very similar to bonds however, there are two key differences:
- Bonds generally attract a higher rate of return
- Bonds can be sold in order to liquidate your assets
Term deposits are therefore handy for smaller sums of money, or if you only want to tie up your money for shorter periods of time.
When to use bonds
Bonds are generally considered to be quite safe and are therefore a good investment option when the stock market is volatile in order to diversify and minimise risk. They are particularly good for retirees, or people that rely on a fixed income as it means fewer surprises and greater reliability in return. Some types of bonds also offer tax free returns, which results in more money in your pocket.
Like everything, bonds are not completely risk free, but they can offer you a certain level of comfort while still returning a profit. If you are interested in investigating the different types of bonds available and the rate of return, you can find some great rates with most large banks and brokerages.
Do you invest in bonds, or would you consider it?
Image by BuhSnarf