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Lesson Five: What is a Bond? Understanding This Fundamental Loan-Based Investment
By Michael Lamonaca 14 July 2025
In our journey to build long-term wealth and embrace the “il dolce far niente” philosophy, it’s essential to understand various types of strategic holdings. Today, we delve into bonds, which are fundamentally nothing more than a loan. When a company, a local government, or even the federal government needs to borrow money, one common way they do so is by issuing bonds. Essentially, bonds serve as a crucial source of funding for these entities.
How Bonds Function for the Investor
When an entity decides to issue bonds, it might do so through a bank. The bank’s role is simply as a mediator, responsible for breaking down these large loans into smaller, manageable pieces and finding buyers for them. These buyers are, quite simply, bond investors. As a bond investor, you receive payments back from your investment, typically twice a year. The amount of these semi-annual payments is determined by the bond’s coupon rate. For instance, if you hold a 5% bond, your return from that bond is 5% of its face value annually.
Understanding Bond Risks
While bonds offer a defined return, it’s crucial to understand their associated risks. Bonds are subject to the risk of company or government default. This means if the issuing entity fails financially, investors may not get their principal investment back. Generally, the federal government is often considered to carry 0% risk in this regard, primarily because it has the power to print more money to cover its obligations. However, other important risks exist, such as those related to interest rates and inflation, which significantly impact a bond’s real return and are topics we explore further in our comprehensive studies.
Priority in Bankruptcy: A Critical Distinction
A key aspect differentiating bonds from stocks lies in the event of bankruptcy. Should a company, unfortunately, face liquidation, bond investors are typically the first to receive payment if there is any money remaining after the company’s assets are sold off. Conversely, common shareholders, who are the owners of the company, are the last to receive any payment, and they seldom recover any of their investment in such scenarios. This demonstrates the bondholder’s senior claim on assets.
Bonds in Market Cycles: A Strategic Consideration
Finally, for the astute, disciplined investor, it’s noteworthy that bond investing can sometimes be expected to be even more profitable than stock investing, particularly when the stock market is experiencing high valuations. This is because bonds and stocks often move inversely: typically, bonds become more attractive (cheaper) when stocks are considered expensive, and vice versa. Understanding this dynamic can be a valuable part of an overall long-term wealth strategy for generating passive income.