Bonds can be great investments in certain situations. Here’s a quick crash-course on bonds and bond investing:
What Are Bonds?
Bonds are debt securities issued by governments, corporations, federal agencies, and more. Basically, they are borrowing your money for a predetermined interest rate and period of time. The interest payments are made over the life of the bond (typically interest is paid every 6 months), but the principal is paid back at the end of the term.
The advantage of bond investing over stocks is that the gains are predetermined. You don’t know how much a stock will be worth when your child heads to college in 10 years, but you do know what income you will receive from a 10-year bond between now and then, in theory.
What Are The Risks?
Even though the gains are pre-determined, that does not mean the payments are guaranteed.
Bonds are assigned risk levels based on the likelihood of the bond issuer to fulfill its obligation to the bond holder. Of course, with less risk there is less income to the bond holder. So an established, secure, profitable company could issue low-risk bonds.
High risk bonds, also known as junk bonds, pay higher interest rates and usually sell at a discount on the secondary market. A bond is determined to be high risk if the company issuing the bond is likely to default on the bond payments.
How Does Bond Investing Work?
The main components of analyzing a bond are Risk, Price, and Maturity. We’ve already touched on risk. The price is the actual price you would pay for the bond. For example, a $5,000 bond may not sell for $5,000. If you bought a bond in the primary market, that is, from the bond issuer, the price typically matches the value of the bond. But in the secondary market, bond prices fluctuate based on the interest rate and the health of the company. So, if a company was doing well when the bond was issued, the interest rate is probably quite low, since the risk would be low. But if that company begins to struggle, someone with that bond might want to sell it.
The interest payments are fixed, so the price would change to accommodate the new level of risk. That $5,000 bond might sell for $4,300. If you paid $4,300, you would get whatever interest payments are left and also get $5,000 back at the end. Sounds like a great deal….if the company stays afloat.
Likewise, the opposite situation can occur. A struggling company might issue a bond with high interest payments. If that company does well, that $5,000 bond might sell on the secondary market for $5,500. The maturity of the bond is simply the amount of time until the principal is paid back and the interest payments stop. The longer the maturity, the greater the possibility the company might have issues. There you have the short-course on bonds….what they are, their risks, and how they work. While you don’t have enough information to match wits with George Soros (that takes experience as well), you do have enough basic knowledge to begin to understand bond investing.
Bonds themselves aren’t complicated; it’s trying to predict the future of the bond issuer that’s a challenge. When you first start investing in bonds, you may want to get your feet wet with some stable, low risk varieties to make some profits you can work with and build your confidence.
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