DaVinci Wealth Presents the Basics of Bond Investing
In financial news, we hear a lot about stocks because of their high potential returns, but less about bonds. Most of us know that a well-diversified portfolio will include both, but because bonds lack the sex appeal of stocks, most ordinary investors know comparatively little about bonds.
What Are Bonds?
A bond is loan, embodied in a certificate of debt, issued by a company or a government. Bonds differ from stocks in that they don’t convey ownership in the company, only debt. In essence, a bond is a loan you make to a company or a government. Bonds are advantageous to their issuers because they are quick ways to raise cash for expansion, and they can be advantageous to investors because of their relative stability and security.
How Do Bonds Work?
A bond is a loan that should eventually be paid back in full. Companies and governments issue bonds, usually in $1,000 increments, called the Par Value, with a specified time in the future that the bond will be paid back in full, known as the Maturity Date. In the meantime, the company pays a certain amount of yearly interest determined by the bond’s interest rate, called the Coupon Rate. A $1,000 bond with a ten-year period and a coupon rate of 8% would therefore pay an investor $80 each year for 10 years. The original $1,000 would also be paid back in the 10th year. Bonds are known as Fixed Income Securities, because you know the exact amount of money you will receive if you buy and hold a bond to maturity.
Why Aren’t Bonds Always Worth the Same Amount?
Most bonds have a Par Value of $1,000, the amount that will be paid back at the maturity date, but they may actually be sold for more or less than that. A bond’s market price is based on several factors: the credit rating of the issuer, the yearly interest paid on the bond, and the length of time left to maturity.
Interest Rate Risk
One factor that causes bond prices to fluctuate is Interest Rate Risk, which has to do with how the bond’s coupon rate, which doesn’t change, compares to changes in interest rates in the overall economy. Consider a bond with a par value of $1,000 and a coupon rate of 5%. In an economy where interest rates were 1% or 2%, this would be a great investment because it will pay 5% every year. But if interest rates increased to 8%, suddenly this bond would not look so attractive, because greater returns could be had by putting that $1,000 elsewhere. The general rule is therefore that when interest rise, bond prices will fall and vice versa.
What’s the Takeaway?
Bonds are I.O.U.s- they represent a loan from you to the issuer, which will provide a fixed amount of income for the life of the bond. The key reasons to buy them are to diversify your portfolio, manage market risk, or to generate income. How much a bond is worth depends on its issuer, par value, time to maturity, and coupon rate. Though less volatile than stocks, bond prices do fluctuate. Investors need to be cautious, because although bonds are often presented as “safe” investments, there are risks, including the financial health of the borrower and interest rate risk.
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