All ‘Bout Bonds
Posted by John Draper | Filed under Investing
Y’all have been asking for some more sophisticated information and investment knowledge and today I’m starting with Bonds.
Bonds are a way for an entity – the federal government, provincial/state or municipal governments, or corporations – to raise money to do they things they want to do. In essence, they are borrowing money from you, and paying interest, so they have the money to do the things they need to do.
Every bond comes with:
- A maturity, the date at which the principal will be repaid, which can be anywhere from 3 to 30 years.
- A par value, which is the face value the bondholder will be paid when the bond matures. This is just the principal amount of the bond and doesn’t include the interest.
- A coupon rate, which is the interest rate the bond is paying. A $1,000 par value bond with a 6% coupon rate will pay you $60 interest yearly. (It’s called a “coupon” because in the old days investors used to have to take the “coupon” in to get the interest.) Many coupon rates are fixed, so their interest rates don’t fluctuate, kinda like a GIC. Some bonds have variable or floating coupon rates so the interest payments change from period to period based on a predetermined schedule or formula. And some bonds pay no interest at all until maturity.
- A credit rating, which indicates how likely it is the bond will be repaid. A Triple A (or AAA) rating is the best. Junk bonds have the worst rating, and the highest interest rates because of their risk.
If you buy a bond and hold it to maturity, you will earn the coupon rate on the bond. So if you invest $5,000 for 5 years at 8%, you’ll make $400 in interest. But you don’t have to hold a bond to maturity because other people may want to buy your bond, and you may want out before the maturity date. In that case, you’ll sell your bond.
Bonds react to changes in interest rates. If you have a 30-year bond paying 9% but new ones are paying only 6%, you’d get a premium price when you sold your bond. If an entity’s credit rating changes after you’ve bought the bond, that could change your bond’s underlying price too.
So if you decide to sell your bond before it matures, you may get more or less than you paid for it depending on a whole bunch of factors. Remember, these factors don’t affect you if you hold your bond to maturity, only if you sell before maturity, at which point you may have a capital gain or loss.
Bonds also respond to demand and supply. As demand increases – as more people want your bond – the price also increases, all other factors being equal. Or if the supply goes down – nobody is issuing bonds with a 10% coupon rate, so you’ve got one of the few last double-digits bonds – the value of your bond will go up.
If you’re going to buy bonds, here’s another term you need to be familiar with: yield to maturity. The YTM tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments you will earn, assuming you reinvest your interest payments at the same rate as the current yield on the bond, plus any gain (if you purchased the bond at a discount) or loss (if you purchased the bond at a premium). YTM is useful because it lets you compare bonds with different maturity dates and coupon rates.
Some bonds have special features that can have an impact on their price, the returns you earn, and the bond’s risk level. Some bonds can be called (repaid) early, which would limit your ability to collect the high interest rate you thought you were getting. Some can be converted into shares of the issuing company so if that company’s shares go way up, you can jump on the bandwagon. And some bonds can be extended, so the maturity is deferred from the original term to a later date, which means you won’t get your money back when you thought you would. All these special features are known up front, so you can make an informed decision as to whether or not to buy the bond.
If you’ve never invested in anything other than a GIC before, and you want to spread your wings, bonds may be the place to look. They are reasonably conservative (meaning they carry less risk than, say, a stock) and they’re reasonably easy to understand if you don’t go getting all fancy… the investment world can turn anything into anything else.
Unless you buy a bond mutual fund or a government issued bond, you’ll need a broker or discount broker to execute the buying and selling (call the “trading”) of the bond.
Here’s a great way to get familiar with bonds — and any other kind of investment you’re interested in learning about — without the risk:
- pick a bond or two or six that you think you might be interested in buying
- research them on the internet or ask an investment house to send you information
- note the price at which you would purchase them if you bought them today
- follow them for six months to a year to see how you would have done if you had bought them.
When your comfortable that you know enough about bonds to actually put your money on the table, buy bonds!
December 9, 2008 at 12:32 pm
As my PC savings account has just dropped in interest today to 2.75% I will seriously consider bonds. I like the idea of following them for 6 months. That’s a terrific idea. Thanks, Gail!
December 9, 2008 at 12:43 pm
Thanks Gail. This is really important information. Keep it coming – we can handle the tougher stuff, even if we don’t comment as much
December 9, 2008 at 2:32 pm
Thanks Gail. We will be debt free in less than two years and have begun to think about what we’re going to do with all our debt money! We appreciate the lesson today; we are going to follow a bond as our first lesson. Planning what we’re going to do with our debt money is a great motivator for getting it all paid off!
December 9, 2008 at 7:25 pm
hmmm… I actually learned something!
December 10, 2008 at 9:40 am
Thanks Gail for simplifying the information about bonds. Love the exercise you gave at the end and I am definitely going to give it a try. And hopefully at the end of the six months, I would be a lot more confident and go for them bonds then!
December 10, 2008 at 11:04 am
Thanks! I agree that this is useful and important information.
Now, I need to get myself into a position where I can finally start investing wisely…
BTW, I bought your 2009 planner! It will be very useful in keeping me on the right track. Thank you again!