Bonds Unplugged: How Bonds Generate Income For Investors

Bonds Unplugged: How Bonds Generate Income For Investors

This post was originally featured on investingfuel.

Bonds are great for people who want regular income with less risk than stocks. Here's a simple explanation of how bonds work and how they can earn you money.

Interest Payments

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When you buy a bond, you lend money to a government or company. In return, they pay you interest regularly, usually every six months or once a year. For example, if you buy a $1,000 bond with a 5% interest rate, you receive $50 each year. This steady interest payment gives you reliable income.

Selling Bonds For Profit

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You can also make money by selling bonds for more than you paid. If interest rates go down after you buy a bond, its price goes up. For instance, if you purchase a bond for $1,000 and interest rates drop, you might sell it for $1,100. This allows you to make a profit from the price increase.

Getting Your Money Back At Maturity

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Bonds have an end date called maturity, which is when you get your money back. When a bond matures, the issuer repays the face value of the bond. For example, if you bought a $1,000 bond, you get that $1,000 back at the end. Plus, you keep all the interest you earned over time.

Yield To Maturity (YTM)

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Yield to maturity is a way to measure how much you can earn if you hold the bond until it matures. It includes all interest payments and any gain or loss from buying the bond for more or less than its face value. YTM helps you see which bond might give you the best overall return. This comparison is useful when choosing bonds to invest in.

Callable Bonds

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Some bonds can be paid off early by the issuer. If interest rates drop, the issuer might call the bonds to save money, meaning they pay you back sooner than expected. Callable bonds often have higher interest rates to make up for this possibility. Knowing if a bond is callable helps you understand how long you might receive interest payments.

Bond Funds And ETFs

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You can also invest in bonds through bond mutual funds and exchange-traded funds (ETFs). These funds pool money from many investors to buy a variety of bonds. They pay out income regularly and spread out risk because they own many different bonds. Professional managers handle these funds, making it easier for you to invest without buying individual bonds yourself.

Tax Considerations

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The money you earn from bonds can be taxed differently depending on the type of bond. Interest from corporate bonds is usually taxed like regular income. Interest from municipal bonds might not be taxed by the federal government, and sometimes not by the state either. Understanding the tax rules helps you keep more of your earnings.

Inflation Protection

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Some bonds, like Treasury Inflation-Protected Securities (TIPS), increase in value with inflation. This means the amount you get back and the interest payments go up with rising prices, helping to keep your money’s value steady. TIPS are a good option for protecting your investment from inflation.