Five Steps to Help you Understand the Bond Market
One of the hardest things to understand for newcomers to the holy trinity of investing (cash, stocks and bonds) are the basic rules and the relatively intricate nuances that all three hold. Today’s blog is going to focus on Bonds and, with that in mind, we’ve put together 5 Steps that will help you to better understand the Bond market and help you to make more sound investments. Enjoy.
- What exactly is a Bond? A bond, basically, is just a loan and, like most loans, it involves a lender (you)and a borrower (the organization issuing the bond). A predetermined interest rate and a maturity date that don’t change are also hallmarks of a bond, as well as the fact that bond issuers, like consumers, have credit ratings. These ratings are based on the likelihood of the lender (you) being paid back and makes them either more or less expensive to borrow. Typically sold in increments of $1000, bonds have a face value or “par” value equal to their exact dollar amount.
- How do you make money with Bonds? When you purchase a bond you’re contracting with the bond “issuer” who agrees to make two payments to their “creditors” (that would be you) a year until the time that the bond reaches “maturity”. Once this happens you get your original “principal” (your original investment amount) back in one lump sum.
The actual amount of your bi-annual payment is determined by the bond’s fixed interest rate. If you’ve ever heard of the term “fixed income investment” it’s because of bonds and because of the fact that, no matter what happens in the market, that payment will be exactly the same for the life of the bond. This is one of the reasons that retirees like bonds in particular, because they know exactly the amount of money that they’re going to get twice a year.
Let’s take a 10 year Treasury bond with a 5% “coupon” or interest rate as an example. If you purchased 10 of these bonds ($10,000.), every year for the 10 year duration of that bond you would be paid $500. a year ($250. every six months) and then, once the 10 year mark passed, you would also get your initial $10,000 investment back. In 10 years you would thus make $5000. on your initial $10,000 investment
- Do interest rates affect Bonds? Changes in interest rates can and will affect the current value of any bond just like credit scores will raise or lower the amount of money it costs to borrow. When interest rates go up, for example, bond value goes down and vice versa. This “inverse relationship” is one of the most confusing parts for most people about fixed income investing.
It’s vitally important to remember that, no matter the current market value of any bond, the amount of money that they pay every six months as well as the actual face value of the bond will never change. These value changes, or what they refer to in the bond market as “paper losses” and “paper gains”, would only affect you if you were to actually sell a bond ahead of its maturation date.
- Who issues (sells) Bonds? The United States government is the largest and most popular borrower (issuer) of bonds. New Treasury bonds are issued with relative frequency and can have maturity times from 30 days up to 30 years. States, cities, corporations and other government agencies (like Fannie Mae) can also issue bonds, as well as foreign governments. As with most any other type of investment, there are some bonds whose issuers are considered to be safe and reliable and there are others that are considered to be much more risky.
- Where can you buy Bonds and who buys them the most? As we mentioned earlier, because they are a safe and predictable source of income retirees are very fond of bonds. Pension funds, investors looking to diversify their portfolios and people who invest in low-risk opportunities also purchase bonds regularly.
Due to this wide appeal there are many different bonds (literally thousands) as well as bond mutual funds and fixed income ETF’s. You can find them through most investment companies or purchase them directly via the Treasury Direct service from the United States government. A piece of advice, if you haven’t opened up an online brokerage account then you are missing out. Personally, I setup a pre-authorized contribution each month to make a deposit into my brokerage account, and I have been doing so for years. With this sort of automation I don’t even miss the money going to my account since I’m not used to having it around anyways. Over the past few years I’ve really had an opportunity to watch it build and grow.
That, dear readers, is a quick and concise overview of what bonds are, how they work and why they make a relatively safe and low risk investment. If you have any questions about bonds including which ones are the “best”, where to buy them or any other questions, please let us know and we’ll get back to you with answers and options ASAP.
Filed under: Investing
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