How Bonds Work

Have you ever wanted to learn about how bonds work? It is essentially a loan from you to the bond issuer. Bonds are used by companies to help raise money, as one of its options on top of loans or mutual funds. If an amount a company needs exceeds what a bank can offer them, they have the option of issuing bonds.

Bonds differ from stocks in that purchasing the stock gives you a piece of the company and that stock rises and falls based on the health of the company. With a bond, you are giving that company a loan and in return, the company promises to pay back the bond price with interest. The interest rates are usually fixed and can be paid twice a year, although they can also be paid annually or even quarterly and monthly.

Some bonds are floating rate bonds, meaning their interest rates are adjusted based on market conditions. Like stocks though, bonds can be traded.

There are several types of bonds. Government bonds are issued by the government. Municipal bonds are issued by states and cities and corporate bonds are issued by companies and corporations. There are also "junk bonds." These types of bonds entice buyers by promising very high yields, but there is no guarantee you will get your money back. If you do, you will be paid quite handsomely though.

In order to determine a company's bond rating and decide whether or not you would like to purchase their bonds, you can look up their bond rating via Standard & Poor's or Moody's Investor Service as well as looking into the company's debt to cash flow ratio, liquidity and business plan.

Bonds are fully paid out to the lender once they reach their maturity and that can last anywhere from months to 50 years.