Introduction to Bonds

Post on: 25 Апрель, 2015 No Comment

Introduction to Bonds

A bond is a debt security, similar to an I.O.U note. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due.

A bond is a loan that pays interest over a fixed term. or period of time. When the bond matures at the end of the term, the principal. or investment amount, is repaid to the lender, or owner of the bond.

Typically, the rate at which interest is paid and the amount of each payment is fixed at the time the bond is offered for sale. That’s why bonds are known as fixed-income securities. That’s one reason a bond seems less risky than an investment whose return might change dramatically in the short-term.

A bond’s interest rate is competitive, which means that the rate it pays is comparable to what other bonds being issued at the same time are paying. It’s also related to the cost of borrowing in the economy at large, so when mortgage rates are down, for example, bond rates also tend to be lower.

THE LIFE OF A BOND

The life, or term. of any bond is fixed at the time of issue. It can range from short-term (usually a year or less), to intermediate-term (two to ten years), to long-term (30 years or more).

Generally speaking, the longer the term, the higher the interest rate that’s offered to make up for the additional risk of tying up your money for so long a time. The relationship between the interest rates paid on short-term and long-term bonds is called the yield curve .

MAKING MONEY WITH BONDS

Conservative investors use bonds to provide a steady income. They buy a bond when it’s issued and hold it, expecting to receive regular, fixed-interest payments until the bond matures. Then they get the principal back to reinvest.

More aggressive investors trade bonds, or buy and sell as they might with stocks, hoping to make money by selling a bond for more than they paid for it. Bonds that are issued when interest rates are high become increasingly valuable when interest rates fall. That’s because investors are willing to pay more than the face value of a bond with an 8% interest rate if the current rate is 5%.

In this way, an increase in the price of a bond, or its capital appreciation. often produces more profits for bond sellers than holding the bonds to maturity.

But there are also risks in bond trading. If interest rates go up, you can lose money by selling an older bond, which is paying a lower rate of interest. That’s because potential buyers will typically pay less for the bond than you paid to buy it.

The other risk bondholders face is rising inflation. Since the dollar amount you earn on a bond investment doesn’t change, the value of that money can be eroded by inflation. For example, if you held a 30-year bond paying $5,000 annual interest, the money would buy less at the end of the term than at the beginning.


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