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Introduction to Bonds

What is a bond? A bond is a loan in the form of a security that obligates the issuer of the bond to pay the owner of the bond interest and principal on specified dates. For example, suppose you pay $9,800 for a $10,000 U.S. Treasury bill that matures 26 weeks after it is issued. In effect you are loaning $10,000 to the U.S. government. At the end the 26 weeks the U.S. government promises to repay the entire $9,800 plus $200 in interest.

Many investors use bonds to generate income knowing they can count on reliable interest payments. Some bonds pay interest every six months and others pay a lump sum when the bond matures. Some investors buy bonds instead of certificates of deposit because they feel they can get a higher rate of return. Others buy tax-exempt bonds to receive income and help manage their tax liability.

Some investors buy bonds when they are afraid to buy stocks because they perceive the stock market to be too volatile and uncertain. They may "park" money in bonds until the stock market becomes more attractive.

Another reason to own bonds is to buy and sell them to make short-term profits. Because the price of a bond changes from minute to minute and day to day, you can sell it for a profit if its price rises after you buy it. When you buy and sell bonds, you are not interested in collecting any interest payment from the bond. Professional bond traders make their living trading the price fluctuations in bonds.

Important Bond Terminology

The following terms describe the characteristics of bonds.

Types of Bonds

Bonds come in all types:

The elapsed time that the principle amount of a bond becomes due. At maturity, which is a specified date for every bond, the issuer promises to pay the bond holder the face value of the bond. No interest payments are made to the bond holder after the bond matures.

Maturities can be months or decades depending on the type of the bond.

Face Value
The face value of a bond is the value of the bond at maturity. So a bond with a $1,000 face value will be redeemed for $1,000 when it matures.

The coupon is the interest rate that the issuer promises to pay the bond holder until the bond matures. The coupon is calculated as an annual percentage of the face value of the bond. For example, a 5% coupon pays $5 for each $100 face value each year. So a bond with a $10,000 face value with a 5 percent coupon pays $500 in interest each year.

Current Yield
The current yield is the coupon divided by the current price of the bond multiplied by 1000. A bond's price changes from the day to day from when it is issued until it matures; its current price can be higher or lower than the issue price. But the coupon always remains the same. Therefore, the current yield changes day to day as the price changes. For example, a bond selling for $1,000 with a 5 percent coupon has a 5 percent current yield, (5%/$1000)*1000. But if the price of the bond fell to $500, the current yield rises to 10 percent. (5%/$500)*1000.

Yield to Maturity
The most comprehensive measure of return on your investment is the yield to maturity which is based on the interest and the capital gains you will receive given that you hold the bond until it matures. YTM is published along with current bond prices. It calculated after the bond is issued using a rather complex formula.

Current Price
A bond's price varies day to day. The primary cause of the price change is a change in market interest rates. If interest rates rise, the price of the bond falls. If interest rates fall, the bond price goes up. If you hold a bold until maturity, the fluctuation of bond prices need not concern you, because you'll receive the face value of the bond. But if you trade bonds, you must carefully watch interest rates moves because they will effect bond prices.

Why do prices go down when rates go up? One explanation is that the current bonds that offer a lower yield and are not as attractive to investors as newer bonds with higher coupon rates. Therefore, investors want to buy the newer bonds so they bid up their price. And if rates go down, prices of the exiting bond goes up because they are more attractive than the newer bond with a lower yield. For bond holders and traders, lower interest rates means that the bonds they own are worth more. For new buyers lower rates means they have to pay more for bonds. Higher rates means bonds are worth less to current bond owners. But bonds will be cheaper to buy.

See Bonds and Bond Funds Can Lose Principal.

Credit Risk

Credit risk measures the ability of a bond issuer to meet its obligations to its bondholders. An issuer that does not pay the promised interest or principal is said to be in default and the bond may be worthless. In this case the bond holder does not receive the promises dollar payment. Standard and Poor's and Moody rate corporate bonds. Bonds that carry little risk are called investment grade and bonds with lots of risk are called junk bonds. In general riskier bonds promise to pay a higher coupon rate than safer bonds A useful rule of thumb to follow is that the higher the coupon rate the higher the risk.

Before you buy a bond, always check its credit rating. Your broker can give the credit rating or you can check the rating at Standard and Poor's and Moody's web sites. Bonds issued buy the U.S. government have never defaulted and are the ultimate safe investment. Credit risk is important to determine for bonds issued by corporations and municipalities and agencies because occasionally these types of bonds have defaulted.

One method to limit the credit risk of bonds is to buy bonds issued by different corporations and municipalities. Like stocks a diversified portfolio of bonds protects you from a possible financial disaster should one of more of your bonds default. Be sure to diversify your bond holdings particularly if you are buying risky bonds that pay a high yield.

Callable Bond
Some bonds have a stipulation that let the issuer pay off the bond before the maturity date. Such bonds are said to be callable. Usually a bond is called if interest rates fall significantly. In so doing the issuer is no longer obligated to continue the relatively high interest payments. When the issuer calls the bond, the bond holder is usually paid more than the face value to compensate for the bond being called.

Bond holders do not like to have their bonds called because they now have to reinvest the proceeds at lower interest rates than the called bond was providing.

Most bonds specify a period during which the bond can not be called. Before you buy a corporate bond, check the call provisions which will tell you if and when the bond can be called.

Liquidity tells you how quickly you can sell a bond without it significantly dropping in price. Suppose you own a bond that matures in 15 years and three years after you buy it, interest rates fall and the price of the bond rises considerably. So you decide to sell it to make a quick profit. If the bond is very liquid, there are many buyers and you will have no problem selling it. But if their are few buyers, the bond is said to be illiquid and you may not be able to sell it at the price that you specify. U.S. government bonds are highly liquid as are most bonds of large well-known corporations. But bonds from more obscure companies may be illiquid.

Should You Buy Bonds or Certificates of Deposit?

Whether you buy bonds or certificates of deposits depends in part on the direction of interest rates.

When you buy a bond you lock in the coupon rate if you hold the bond until it matures. So buying bonds in a falling interest rate environment makes sense. Also, as interest rates fall, the price of your bond will increase so you could sell it for a profit if you wanted.

If you buy a certificate of deposit (CD) while interest rates are falling, you will lock in the rate for the current CD but you will receive a lower rate for the next CD that you buy. For example, when rates are falling, buying a bond with a 20-year maturity is more profitable than buying four five-year CDs.

But if interest rates are rising, buying successive CDs if more profitable than buying one bond with a multi-year maturity. Each time that you renew the CD will receive a higher rate but the yield for the bond remains the same. So if you want to own bonds when rates are rising, buy short maturity bonds so you can reinvest your money at higher rates.

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