A bond is nothing more than a debt. If you have forgotten your lunch and you borrow $20 from your friend, you owe them a debt. If you gave them a piece of paper indicating the amount of the debt, this piece of paper would be similar to a bond.
Companies, cities and countries may decide to issue bonds instead of borrowing from a bank. The only difference between the bonds they issue and the piece of paper that you gave to your friend in the previous example is that bonds generally have an interest rate and a maturity date (the deadline to pay back the loan).
To illustrate how bonds work, imagine the following scenario. Hardbacon has become the number one finance site in Canada and decides, as a way to thank Canadians for their support, to build an arena to enable Team Canada to train in state-of-the-art facilities. To do this, Hardbacon needs money and decides to issue a series of $1000 bonds at an interest rate of 5% that will expire in 10 years. If you buy one of these bonds, it’s as if you’ve loaned Hardbacon $1000, who will repay it in 10 years. Of course every year you will earn 5% interest on your loan, which is $50 per year. So, after 10 years, Hardbacon will repay your $1000 and you will have earned $500 in interest ($50 per year for 10 years).
You certainly won’t make millions of dollars with this kind of investment, but you will secure a fixed and predictable income. Therefore the closer we are to retirement, the more we tend to increase the percentage of bonds in our portfolios. This way, we protect ourselves from the unpredictability of stock market fluctuations.
On thing to know is that in general, the later a bond’s expiration date (1 year, 10 years, 30 years, etc.), the higher the interest rate. In fact, over a year, there’s a good chance that the bond issuer will be able to pay your interest and repay your money. But over 10 years or even 30 years, who knows what could happen? If the risk increases, the potential reward must also increase.
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