Bonds are among a number of investments known as fixed-income securities. They are debt obligations, meaning that the investor loans a sum of money (the principal) to a company or a government for a set period of time, and in return receives a series of interest payments (the yield). When the bond reaches its maturity, the principal is returned to the investor.
Making Money From a Coupon-Paying Bond
There are two ways that investors make money from bonds.
- The individual investor buys bonds directly, with the aim of holding them until they mature in order to profit from the interest they earn. They may also buy into a bond mutual fund or a bond exchange-traded fund (ETF).
- Professional bond traders dominate a secondary market for bonds, where existing issues are bought and sold at a discount to their face value. The amount of the discount depends partially on how many payments are still due before the bond reaches maturity. But its price also is a bet on the direction of interest rates. If a trader thinks interest rates on new bond issues will be lower, the existing bonds may be worth a little more.
In either case, the owner of the bond receives interest payments,known as the coupon, throughout the life of a bond, at the interest rate that was determined when it was issued.
Key Takeaways
- A coupon-paying bond pays a pre-determined amount of interest, usually twice a year until the date the bond matures.
- A zero-coupon bond is bought at a discount from its face value, and the investor receives the full face value when it matures.
- The interest paid on a bond may be pre-set or may be based on prevailing interest rates at the time it matures.
For instance, if you invested $1,000 in a 10-year bond with a coupon rate of 4%, the issuer would send you a coupon (interest) payment of $40 every year. Most bonds pay twice a year, so you would receive two checks for $20 each.
Making Money From a Zero-Coupon Bond
Investors in zero-coupon bonds receive no payments for their money until the bond matures. They buy the bond for an amount that is less than its face value. When it reaches its maturity, they are paid the full face value of the bond.
The zero-coupon bond also is known as a discount bond. U.S. Treasury bills (T-bills) and U.S. savings bonds are two examples.
In the secondary bond market, bonds are bought and sold at a discount to their face value based on the number of payments outstanding, plus the trader's bet on the direction of interest rates.
Most zero-coupon bonds have a pre-set face value and therefore pay a pre-set amount of moneyat maturity. Some bonds are inflation-indexed, meaning the face value is determined at maturity. The amount paid will be based on a standard measure such as the consumer price index plus a premium.
Types of Zero-Coupon Bonds
Bonds are issued with maturity dates that vary in their length of time.
Zero-coupon bonds that are considered short-term investments typically have a maturity of no more than one year. These short-term bonds are usually called bills.
A zero-coupon bond that is a long-term investment may have a maturity date of 10 to 15 years or more.
Coupon-Paying Bond Vs. Zero-Coupon Bond
Coupon-paying bonds are a frequent choice of older investors and retirees who value the steady income that the payments provide and the relative safety of bonds as an investment.
Those short-term Treasury bills have the same benefits as reliable income supplements and safe investments.
The long-term zero-coupon bond holds little attraction for most older investors and retirees, who are unlikely to want to tie up their money for decades.
Such a long-term bond might, however, be useful as part of a young family's savings plan. It also can be used by wealthy investors as a vehicle for passing on an inheritance.
Tax Benefits of Zero-Coupon Bonds
Zero-coupon bonds issued in the U.S. retain an original issue discount (OID)for tax reasons.
Zero-coupon bonds often input receipt of interest payment, or phantom income, despite the fact the bonds do not pay periodic interest.For this reason, zero-coupon bonds subject to taxation in the U.S. can be held in a tax-deferred retirement account, allowing their investors to avoid tax on future income.
If a zero-coupon bond is issued by a U.S. local or state government entity, interest is free from federal tax and generally exempt from state and local tax as well.
FAQs
In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..
How does an investor make money from a bond? ›
There are two ways that investors make money from bonds. The individual investor buys bonds directly, with the aim of holding them until they mature in order to profit from the interest they earn. They may also buy into a bond mutual fund or a bond exchange-traded fund (ETF).
How would investors invest in bonds? ›
Unlike stocks, bonds aren't publicly traded on an exchange. Instead, bonds are traded over the counter, meaning that you must buy them from brokers.
What a bond is and how an investor makes money from it? ›
A bond is a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time. The entity repays individuals with interest in addition to the original face value of the bond.
How might an investor benefit from investing in a bond? ›
Bonds tend to be less volatile and less risky than stocks, and when held to maturity can offer more stable and consistent returns. Interest rates on bonds often tend to be higher than savings rates at banks, on CDs, or in money market accounts.
How do bonds generate income for investors brainly? ›
Explanation: Bonds generate income for investors through regular interest payments made by the issuer of the bond. When an investor purchases a bond, they essentially lend money to the issuer, such as a government or corporation, in exchange for periodic interest payments.
How do brokers make money on bonds? ›
Bond brokers make money off the spread at which they exchange bonds between traders, and take little risk in the process since brokers typically do not hold long or short positions in bonds. For example, if a broker purchases a bond for $98 and sells it for $99, they earn a spread of $1 on the transaction.
How do bond funds work? ›
Bond mutual funds
Unlike individual bonds, which usually make semiannual interest payments, bond funds usually make monthly distributions that can be paid directly to the investor or reinvested into the fund to compound returns.
Why would investors sell bonds? ›
Investors of bonds, however, may decide it is more advantageous to sell a bond rather than hold it to maturity. Some of these reasons include anticipation of higher interest rates, that the issuer's credit will be lowered, or if the market price seems unreasonably high.
What is the safest bond to invest in? ›
Treasuries are generally considered"risk-free" since the federal government guarantees them and has never (yet) defaulted. These government bonds are often best for investors seeking a safe haven for their money, particularly during volatile market periods. They offer high liquidity due to an active secondary market.
A put bond is a debt instrument with an embedded option that gives bondholders the right to demand early repayment of the principal from the issuer. The embedded put option acts an incentive for investors to buy a bond that has a lower return.
Which best describes how an investor makes money? ›
Final answer:
Investors make money from equity investments through capital gains achieved by selling assets at a profit.
What is the best investment right now? ›
11 best investments right now
- High-yield savings accounts.
- Certificates of deposit (CDs)
- Bonds.
- Money market funds.
- Mutual funds.
- Index Funds.
- Exchange-traded funds.
- Stocks.
There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid. With most bonds, you'll get regular interest payments while you hold the bond. Most bonds have a fixed interest rate. Or, a fee you get to lend it.…
How do bonds work for dummies? ›
The people who purchase a bond receive interest payments during the bond's term (or for as long as they hold the bond) at the bond's stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond's face value.
Why do investors prefer bonds? ›
Generally, yes, corporate bonds are safer than stocks. Corporate bonds offer a fixed rate of return, so an investor knows exactly how much their investment will return. Stocks, however, typically offer a better rate of return because they are riskier.
Can investors lose money on bonds? ›
Key Takeaways. Bonds are often touted as less risky than stocks—and for the most part, they are—but that does not mean you cannot lose money owning bonds. Bond prices decline when interest rates rise, when the issuer experiences a negative credit event, or as market liquidity dries up.
Why would an investor sell a bond? ›
Investors trade bonds for a number of reasons, with the key two being—profit and protection. Investors can profit by trading bonds to pick up yield (trading up to a higher-yielding bond) or benefit from a credit upgrade (bond price increases following an upgrade).
How does an investor earn money by buying bonds at a discount? ›
How does an investor earn money by buying bonds at a discount? By paying the investor fixed interest at for a specific amount of time. What three organizations help ensure value and prevent dishonesty in the bond market? Standard and poor, moody's, securities and exchange commission.
