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
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 does an investor make money from investing in bonds? ›
Summary: Bonds are a type of fixed-income investment. You can make money on a bond from interest payments and by selling it for more than you paid. You can lose money on a bond if you sell it for less than you paid or the issuer defaults on their payments.
How do companies make money from bonds? ›
Investors who buy corporate bonds are lending money to the company issuing the bond. In return, the company makes a legal commitment to pay interest on the principal and, in most cases, to return the principal when the bond comes due, or matures.
Do investors make money? ›
Investors may earn income through dividend payments and/or through compound interest over a longer period of time. The increasing value of assets may also lead to earnings. Generating income from multiple sources is the best way to make financial gains.
How do most investors buy 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. However, you can buy U.S. Treasury bonds directly from the government.
How do investors make money from mortgage bonds? ›
Lenders sell a mortgage bond to real estate investors, who receive interest payments on mortgage loans until they are paid off. An investor has a claim on the assets put up as collateral, such as a house, and can repossess them in the event of a default.
How does an investor earn income from a perpetual bond? ›
Ans. The major benefit of investing in perpetual bonds is fixed regular interest payments that serve as a fixed source of income. Moreover, interest payment is perpetual, i.e., it continues without any maturity date. The interest earned from perpetual bonds is added to the gross total income of respective bondholders.
How do investment banks make money on bonds? ›
Investment banks earn commissions and fees on underwriting new issues of securities via bond offerings or stock IPOs. Investment banks often serve as asset managers for their clients as well.
Do bonds make a lot of money? ›
Average returns: Long-term government bonds historically earn around 5% in average annual returns, versus the 10% historical average annual return of stocks. Risks: A bond's risk is based mainly on the issuer's creditworthiness. Interest rates also influence a bond's value.
How do companies lose money on bonds? ›
The main ways to lose money on bonds include price decreases due to interest rate increases, default or bankruptcy of the bond issuer, call risk, reinvestment risk, and inflation risk.
How Do Investors Make Money? Investors make money in two ways: appreciation and income. Appreciation occurs when an asset increases in value. An investor purchases an asset in the hopes that its value will grow and they can then sell it for more than they bought it for, earning a profit.
How do investors make their money back? ›
Dividends. One of the most straightforward ways for companies to pay back their investors is through dividends. A dividend is the distribution of some of a company's profits to its shareholders, either in the form of cash or additional stock.
How do investors make money from funds? ›
The first way is to see a return from the interest and dividend payments off of the fund's underlying holdings. Investors can also make money based on trades made by management; if a mutual fund earns capital gains from a trade, it is legally obligated to pass on the profits to shareholders.
How do bonds work for investors? ›
Bonds can be issued by companies or governments and generally pay a stated interest rate. The market value of a bond changes over time as it becomes more or less attractive to potential buyers. Bonds that are higher-quality (more likely to be paid on time) generally offer lower interest rates.
Who are the main investors in bonds? ›
Broker-dealers are the main buyers and sellers in the secondary market for bonds, and retail investors typically purchase bonds through them, either directly as a client or indirectly through mutual funds and exchange-traded funds.
What is the best bond to put money in? ›
Best Bonds to Invest In
- 10-year Treasury Note.
- I Savings Bonds.
- iShares TIPS Bond ETF.
- Nuveen High-Yield Municipal Bond Fund.
- Vanguard Short-Term Corporate Bond Index Fund.
- Guggenheim Total Return Bond Fund.
- Vanguard Total International Bond Index Fund.
- Fidelity Short-Term Bond Fund.
Bottom line. Ultimately, the decision on whether or not to hold bonds and in what amount will depend on the unique circ*mstances of each individual investor. But the rise in interest rates has made bonds more attractive than they've been in over a decade.
Do bonds pay dividends or interest? ›
Most bonds pay guaranteed amounts of interest each year, called coupon payments. Because bonds pay interest, bond funds do as well. Balanced funds invest in stocks and bonds.
