Bonds (no, not James…) |
Why buy bonds?
In most cases, individual investors purchase bonds to maintain a stream of income (coupon payments),
or preserve their capital. Because bonds provide predictable payments of interest, they are used to
augment retirement incomes, or secure a steady cash flow at a stated interest rate.
What is a bond?
A bond debt security. When you buy a bond, you are in effect lending an entity (like a government or a
corporation) your money. In turn, they promise to pay you a specified rate of interest for a specified
period of time. At the end of that time, the bond "matures" and the issuer at that time repays the face
value of their debt to you (face is typically $1,000). Bonds are issued from a variety of entities, such
as US governement, municipalities, corporations, federal agencies, and foreign governments. They are also
available in a variety of maturities, and grades.
Among the types of bonds you can choose from are: U.S. government securities, municipal bonds, corporate bonds,
mortgage and asset-backed securities, federal agency securities and foreign government bonds.
How do interest rates affect the price of my bond?
Interest rates and bond prices have an inverse relationship: as interest rates fall, bond prices rise;
as interest rates rise, bond prices fall. Why is this? Well, it is mainly a function of mathematics.
Here is an example: Let's say that you have purchased a bond for $1,000 with a coupon rate of 5%. Therefore,
your annual payments are $1,000 * 5% = $50. If interest rates rise to 7.5%, then if you were to purchase a bond
now, you interest payments would be $75. So, for your $50 to yield 7.5% (at today's prevailing
interest rates), then your bond would be worth $866.67, (which mathematically is 50/866.67 = 7.5%,
the current prevailing rate). The converse is true in a falling interest rate environment.
For instance, if you hear on the radio or TV that bonds are rallying, that means that the prices
for them are up, and alternatively, interest rates are down.
What else can affect the price of my bonds?
Another factor affecting bonds is credit quality. For instance, US Government
obligations are rated AAA, which is the highest rating. It is viewed that these i
nvestment are secured, and there is not chance of bankruptcy, or risk of non-payment.
Standard and Poors, Moody's Investor Services and Fitch's are bond rating agencies
which assigns ratings to the creditworthiness of bonds. Normally it is viewed that
anything above BBB is investment grade, and anything below that becomes speculative.
The grades go all the way down to D (for default).
How does this affect your bond? Bonds as we learned are priced in response to interest rates,
but also in response to credit worthiness. For instance, a C rated bond would pay a lot
higher interest rate than a AAA bond, due to the investor assumes more risk with a C rated
bond then a AAA rated bond. So one can assume that if your bond becomes downgraded, that the
result would be an erosion in current market price.
Where can I find more information on Bonds?
The Bond Market Association