More About Bonds
Posted by Gail | Filed under Investing
Some people believe that bonds are very safe investments — that there is no capital risk associated with an investment in bonds. Not so. Bonds carry the risk that the company or government that issued the bond will not be able repay the money borrowed, referred to as credit risk. And in today’s climate of whole countries going bust, that’s a very real risk.
Just because a bond has a good rating doesn’t mean that all risk has been eliminated. Bonds are also susceptible to interest-rate risk (as all fixed-income investments are), along with market risk, which refers to the uncertainty about the future price of an investment due to changing economic conditions or unpredictable changes in investor psychology and attitudes. For example, the announcement by the federal government regarding lower-than-expected economic growth is likely to result in a broad decline in bond prices as investors lower their expectations of corporate earnings. Grave illness or assassination of a political figure can affect the general market as well.
Rating agencies will signal that they are considering a rating change by placing the security on “under review”. These ratings are made available through the agencies’ rating desks or through their online ratings access, as well as being well publicized in the financial press.
Since the only time interest-rate-volatility risk is a factor with a bond is when you choose to sell it before maturity, a good way to minimize this risk is to buy bonds with different maturity dates based on your specific needs. Let’s say, for example, that your daughter will be going to college in ten years. This year she could buy a bond that matures in ten years, next year she could invest in a bond that matures in nine years and so on. When it comes time to use the money, all the bonds will have matured. Of course, this only works if you are reasonably sure she won’t need the money earlier.
Another strategy in buying bonds takes advantage of the changes in interest rates. For example, if interest rates are currently at a high and the yield curve is inverted (indicating that all the people in the know expect rates to fall), you might decide to buy a bond now to sell it for a profit later when the rates do fall.
A bond’s price is based on a number of factors including interest rates, supply and demand, credit quality, maturity and tax considerations. Naturally, bonds that are newly issued sell at face value. However, those traded in the secondary market fluctuate in respond to demand and supply, along with changes in interest rates and credit quality. When a bond is selling above its face value, it is said to be selling at a premium. When a bond’s price falls below its face value, it is said to be selling at a discount.
Yield is the return you actually earn on the bond based on the price you paid and the interest payment you receive. A bond’s current yield is the annual return on the dollar amount paid for the bond. It is calculated by dividing the bond’s interest payment by its purchase price. Let’s say a bond was issued at $1000 with an interest rate of 8%, your yield would be 8% (80 ÷ 1000 = 8%). If the value of the bond was lower than the original issue price when you bought it, so you only ended up paying $900 for the bond, your yield would be 8.9% (80 ÷ 900 = 8.9%). So buying a bond at a discount will increase the yield on the bond.
Yield to maturity (or yield to call) is considered more meaningful because it tells you the total return you will receive by holding the bond until it matures (or is called). It also lets you compare bonds with different maturities and coupons. To calculate a bond’s yield to maturity, add the total interest received from your date of purchase until maturity (don’t forget the compounded return) along with any gain or loss (if you purchased the bond at a discount or premium). Yield to call is calculated in much the same way except it assumes that a bond purchased at a premium will be called and that the investor will receive face value back at the call date.
Next week: Bonds Quotes
Last week: Fixed-Income Investments
July 6, 2010 at 6:00 am
Not a bond comment at all, but Suzanne, how are you making out?
July 6, 2010 at 7:12 am
so far in my investment life I’ve steered clear of the bond market. I’m not sure why that is, but when the credit crisis happened bond yields went through the roof, while equities tanked. I could have helped balance out the pain I was feeling from the equities I held. Lesson learned I guess.
regards,
Jason
July 6, 2010 at 9:11 am
I can’t wait for the picnic in the park! Last year was so much fun. I’m really looking forward to seeing you again Gail, along with the other readers & bloggers!!
July 6, 2010 at 12:56 pm
Hello Everyone, i really hope to meet all of you there, specially my girlfriend Gail…. (shhh don’t tell my wife !).
July 6, 2010 at 2:30 pm
good info gail; i’m not quite to the investing other than my 2 plans at work (one is completely employer-funded while the other is a 403-b that matches 3% as long as i invest at least 6% – not turning down free money!). while i still have debt to pay i feel i need to concentrate on that and once i finish up there, i’ll have a bit more to split between emergency fund, savings, and retirement funds.
this is one of those blogs i mark for “information” so i can have it when it IS time to seek investments.
suzanne, hoping you are coming along better today; it sounds like you’ve made some positive changes & are advancing along a bit. good for you; though a nice foul temper tantrum certainly serves its purpose! the boarder will help immensely!
maureen-dear maureen. sending you my prayers & good karma for your strength & successful recuperation. i will miss you so very much!
July 6, 2010 at 5:28 pm
I wish I could make it to picnic in the park, but I won’t be in the Toronto Area until the 20th when I will be going to rock out with my favourite band: Bon Jovi. I hope you have nice weather, good food and good company.
July 6, 2010 at 5:44 pm
Take a look at this column Rob Carrick from the Globe & Mail wrote in October 2009 on how bonds can protect you if the stock markets and the economy both stumble.
http://www.facebook.com/l/9f190qHB2P01wuJ4ppDQKykFyxg;tgam.ca/B2a
July 7, 2010 at 12:30 am
It’s unfortunate that it is so hard for people to purchase bonds themselves without buying into a bond fund of some kind. I find there is still a lack of clarity when it comes to bonds. Also, unless you have at least $10K per bond to invest, you usually get hit with steep commissions.
July 11, 2010 at 8:34 am
I am so sorry, Gail and others…we won’t be able to make it to the picnic today…we’ve got 2 sick mom’s here
Very disappointed. Hope everyone has a fantastic time.
July 13, 2010 at 4:37 am
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