|
Bond Investing - What are they, and how to
invest in them
Bond – Investing Bonds: Juggling
All The Variables
Bad Ian Fleming reference aside, the prime function of a bond is that you're
lending money to a corporation for a fixed term, and getting a fixed rate of
return, called the coupon rate, based on the original capital invested, out of
it. The trick is figuring out how much of your investment portfolio should be in
bonds versus other investment vehicles.
The principle advantage of bond investing is that they're rated in their risks.
The bond has a term where it pays off (say 10 years) at which point you get your
initial investment back. Bonds will pay a steady income of whatever their return
rate is, taken as a percentage of the initial investment. Thus, if you invest
$100,000 in a series of bonds that return interest at a coupon rate of 3.5%,
each year, you'll get $3,500 of interest income. The big advantage of bonds is
their steady income stream, and that you get the initial investment back when
you're done.
So, what's a sensible investment strategy for bonds? Well, it depends on the
type of bond you're buying. Short term (less than five year) bonds tend to have
low coupon rates, but have the advantage that your assets aren't tied up for
long periods of time. A mix of short term bonds means that if an emergency
strikes while you're retired, you're very likely to have a bond maturing to give
you an immediate lump sum of cash. Medium term bonds tie your money up for
longer stretches of time (typically more five to seven or ten years.), while
long term bonds tie your money up for 10 to 30 years or more. The coupon rate
will also vary with the credit worthiness of the company the money is lent to;
lower credit ratings result in higher coupon rates, and the highest credit
rating is typically governmental bonds; this is one reason why the 30 year
Treasury bill (or T Bill) is used as a baseline bond metric.
There's more to bond investing than the coupon rate. Since bonds can be bought
or sold at any time, very few people hold bonds to their full maturity, and bond
funds keep portfolios of bonds with different maturity rates. In general, when
the interest rate goes up, the price of an existing bond goes down, because
buying a new bond at the higher rate gives a higher rate of return. When the
interest rates go down, the bond price of an existing bond goes up, because it
gives a higher rate of return than a newly purchased bond would.
Finally, there's the
yield of the bond, which is a bit more involved, but simple to
calculate. The yield rate is the ratio of the annual return of the
coupon rate divided by the current purchase price of the bond. For
example, that $100,000 bond with an annual payout of $3,500 has a
yield of 3.5% if it's bought at $100,000. If it were purchased at
$90,000 (due to an increase in interest rates), it would still
return $3,500 per year, and would have a yield of $3,500/$90,000 =
3.8%. Just like the purchase price varies inversely with the
interest rate, so does the yield.
So now we've answered
the question how do i invest in bonds - now the
question is, what more can you tell me?
If you want to find a glossary of bond
terms, you can visit the website of the Bond
Market Association. For more information
about bonds, you can also read one of its
publications, An Investor's Guide to Bond
Basics.
"Bond fund" and "income fund" are terms used to describe a type of
investment company (mutual fund, closed-end fund, or Unit Investment Trust
(UIT)) that invests primarily in bonds or other types of debt securities.
Depending on its investment objectives and policies, a bond fund may
concentrate its investments in a particular type of bond or debt
security—such as government bonds, municipal bonds, corporate bonds,
convertible bonds, mortgage-backed securities, zero-coupon bonds—or a
mixture of types. The securities that bond funds hold will vary in terms of
risk, return, duration, volatility, and other features.
Zero coupon bonds are bonds that do not pay
interest during the life of the bonds.
Instead, investors buy zero coupon bonds at
a deep discount from their face value, which
is the amount a bond will be worth when it
"matures" or comes due. When a zero coupon
bond matures, the investor will receive one
lump sum equal to the initial investment
plus interest that has accrued.
Municipal bonds are debt securities that
states, cities, counties, and other
governmental entities issue to raise money
for public purposes—such as building
schools, highways, hospitals, sewer systems,
and other special projects. A primary
feature of many municipal securities is that
the interest you receive is generally exempt
from federal income tax. The interest may
also be exempt from state and local taxes if
you live in the state where the bond is
issued.
Corporate bonds are debt securities issued
by private and public corporations.
Companies issue corporate bonds to raise
money for a variety of purposes, such as
building a new plant, purchasing equipment,
or growing the business.
Chances are, even if you have never received a savings bond in your name or had
anything to do with them, you probably have some idea of what a U.S. savings
bond is. If not, it’s okay; they seem to be dwindling in popularity as of late,
as fewer people are educated every day on the benefits of a U.S. Savings Bond.
If you aren’t really sure what a U.S. savings bond is and how they may or may
not have a place in your life, read on for more information.
A savings bond is a treasury security for investors. In essence, investors are
loaning the government money. They are issued both as paper bonds and electronic
savings bonds. They cannot be traded but can be redeemed after only one year.
There are no dividends, per se, with a savings bond, as the interest payments
are simply added on to the value of the bond, but as tax-deferred items, the
interest doesn't have to be reported to the government until the bonds are
cashed.
Bond investing offers almost as many options as investing in stocks. Bonds are a
critical component of the diversified portfolio, and taking time to compare
stocks vs bonds in terms of one's investing goals is important to creating a
balanced portfolio.
|
