Bonds
Regardless of whether or not you actually own bonds, you should
probably read this section. Even if you decide not to invest any money
in this way, you need to understand how bonds work so that you have a
basis of comparison with other investment options.
The second major category to consider when you are investing is bonds.
Essentially what you do is loan some of your money to a corporation or
government entity. Your expectation is that at some point in the future
you will receive back all of your investment plus interest. Interest is
usually paid on a regular schedule and is fixed at the time that you
purchase the bond. When bonds are first issued, they are sold through
brokers or directly to investors at or near “par” value. Par value is
the amount of money that the investor will be paid when the bond comes
due.
After a bond is issued, a secondary market develops where bonds are
bought and sold through brokers. When a bond is traded on the secondary
market it may be for more or less than the original purchase price
depending on a number of factors related to the financial strength of
the issuer and what has happened to interest rates since the bond was
issued. If rates have risen and it is possible for investors to get
better rates on new bonds than you are getting on yours then the value
of your bond will have declined. If, on the other hand, interest rates
as a whole have dropped since you acquired your bond it may be worth
more that you paid for it initially. As a general rule, bond prices tend
to move in the opposite direction to interest rates.
The financial strength of the issuer impacts the original interest rate
of the bond and the price of the bond in the secondary market. Strong
companies and government entities with taxing authority are considered
low risk and so they can offer lower interest rates than other entities.
If it looks like the company or government entity that issued the bond
is having financial difficulty and may have trouble paying the interest,
then the value of the bond will decline. If the company looks like it
will have difficulty repaying the principal when it comes due, then the
decline in the value of the bond can be quite steep. Bonds are rated by
bond rating services that examine the underlying financial strength of
the issuer and give it a grade so that investors can assess the level of
risk of the bonds on the market. It is common for the rating to change
after a bond has been purchased and if it is downgraded, the price will
go down and the holder will suffer a capital loss.
A final consideration to be aware of is the amount of time until the
bond matures. If interest rates have dropped and your high rate of
interest is locked in for several years, then your bond would be worth
more than a bond with the same interest rate that matures in the near
future. The opposite is also true. If interest rates have risen and you
hold a bond with a low interest rate that will mature in several years,
it will be worth less than bonds with the same interest rate that mature
in the near future. The value of bond nearing maturity tends to move
towards its par value regardless of whether is has a rate that is higher
or lower than newly issued bonds.
All of this is reflected in “Yield to Maturity”. Simply stated, it is
the expected annualized return on a bond given its present value, its
value at maturity and the interest payments. It allows you to compare
bonds with each other and decide which one is the best for your
portfolio.
Government Bonds
The government of the United States is the largest issuer of bonds in
the world. Since the bonds are backed by the “full faith and credit” of
the United States (and its considerable taxing authority) they are
considered safe and therefore are able to offer the lowest interest rate
of any taxable bond. There are a number of different types of bonds that
are available to the average small investor and they are always coming
up with new ways to encourage investment.
Corporate Bonds
Corporations also issue bonds for a variety of business purposes.
Since they are unable to tax the population, their ability to pay
interest and repay the bond is dependent on their success as a business.
For this reason, they are considered to be higher risk than government
bonds and therefore they have to pay a higher rate of interest in order
to attract investors.
There are bond-rating services that examine the financial strength of
bond issuers and rate them as to their ability to pay interest on time
and repay principal at maturity so that individual investors have some
basis for comparing one bond to another.
Municipal Bonds
Municipal bonds are bonds issued by state or local governments. The
interest paid on the bond is exempt from federal taxation and usually
from state income tax if the holder lives in the state that issued the
bond. This allows the holder to receive a lower rate of interest than
would otherwise be possible and still come out ahead from an after-tax
point of view. For individuals who are in a relatively high marginal tax
bracket, this can be a good way to invest.
High Yield (Junk) Bonds
High Yield bonds are really just corporate bonds as covered above.
However, they are bonds issued by corporations who may have difficulty
in paying the interest and repaying the principal. For that reason, the
value of the bond has fallen to the point where the required interest
payments are relatively high as a percentage of the value of the bond.
High yield comes with high risk and individuals should be very careful
about trying to increase their income by going heavily into these types
of bonds.
Zero Coupon Bonds
Zeros are issued at a low price and gradually increase in value until
they reach their face value at maturity. During this time they pay no
interest. Upon maturity, you receive face value for the bond and the
interest rate is figured on the annualized return that would have been
needed to raise the low investment price of the bond to the maturity
price. There are some tax implications for holding zeros that need to be
understood before you decide that this is the way to go. Also, since
everything is paid back at the very end, you need to make sure that the
issuer is strong financially and likely to remain that way during the
time that you hold the bond.
International Bonds
These are essentially bonds issued by governments other than the
United States. They usually pay higher rates of return than US bonds
and, depending on the country, can be relatively safe. They do carry
additional risk but help investors by allowing for more diversification
than would otherwise be the case.
Risk Factors
Every investment carries with it a certain amount of risk. With
bonds, there are three primary sources of risk. First, there is interest
rate risk. Since bonds tend to move in the opposite direction to
interest rates, a sharp rise in interest rates can mean a sharp decline
in the value of your bond. It may be worth less than you paid for it at
a time when you need to sell it and if that happens you will experience
a capital loss.
A second source of risk is purchasing power risk. If the rate of
inflation is greater than the rate of interest being paid by your bond,
then you may end up with less purchasing power than you had when you
initially purchased it. Purchasing power risk is more prevalent in
bonds, even over the long term than it is in either stocks or real
estate.
Finally, there is financial risk. Even if everything is working out well
in terms of interest rates and purchasing power, the specific company
that issued the bonds may have financial difficulties. This will be
known in the investment markets and the price of the bonds they issued
will decline as a result.
As is always the case, risk is managed through diversification. Instead
of investing in the bonds of just one entity, invest in the bonds from
several entities and with different maturities. Then, if one of the
companies that issued your bonds experiences financial difficulties or
if short-term interest rates rise sharply, you have other bonds to
offset the decline. By extending your diversification to other
investment types (stocks and real estate) you can reduce your other risk
factors as well.
For a more complete discussion of the types of bonds that are available,
how they are rated and how you would go about buying individual bonds,
visit the web sites listed at the end of the chapter. There you will
find out more about how bonds can be bought and sold, how they are
rated, how they reduce risk, and assist people who are moving towards
their goals.
WEB SITES:
http://www.investinginbonds.com
http://www.savingsbonds.gov/sav/sav.htm
http://www.usaaedfoundation.org/financial/bi08.asp
http://municipalbonds.com/
http://www.bondsonlinequotes.com/
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