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© 1999-2007 by Marabella Books

 

 

 

 

 


Bonds

We have discussed how to “work that money” by keeping pace with inflation (CDs and money market funds help you keep pace with inflation).  Maybe you want a portion of your money to outpace inflation, or you want to generate investment income without taking a lot of market or liquidity risk.  Then, it’s time to look at bonds.

Bonds are securities in which investors (“bondholders”) “lend” money to a company or government entity (the “issuer”).  In return for the opportunity to “borrow” the money, the issuer is obligated to pay-back the bondholder interest (the cost of borrowing) plus the principal.  For investors, bonds are used to generate investment income greater than CDs or money market funds, or to provide a conservative alternative to stocks.  For the issuer (whether a local, state or federal government or corporation), the purpose of bonds is to borrow capital to fund projects. 

There are two broad categories of bonds:  general obligation (also referred to as G.O.s) and revenue.

1. General obligation bonds are backed by the taxing authority of the issuer.  In other words, G.O. bond investments are paid back by the issuing governmental body with tax dollars.  

2. A revenue bond can be issued by a governmental body that taxes, but the bond investors are paid back in revenues generated by the facility constructed by mandate of the bond.  For example, if a bond is issued to construct a bridge, the tolls from the use of the bridge are used to repay the bond investor. 

A bond has a maturity term of about five years or more.  If you buy a bond, treat it as if you will not have access to that money until the bond term ends.  But what if you need access to the investment before the bond matures?  This is where understanding bonds becomes a little challenging. 

Whenever you invest in bonds, you risk that the bond may not be worth what you purchased it for after the purchase and during the entire maturity period, because interest rates have fluctuated.  If interest rates increase after you buy the bond and before it matures, the price of your bond will decrease.  If interest rates decrease, the price of your bond will increase.   Here’s an example:

Let’s say you purchase a bond that costs $1,000 (also referred to as “face value”).  The interest (or “coupon”) is 8%.  If you multiply 8% times $1,000 you can expect to be paid $80 annually, or $20 a quarter or $40 semi-annually depending on when your bond pays interest.  The math works the same if, for instance, you retired with $1,000,000 and you invest all of it in bonds.  You would have 1,000 bonds with $80,000 in interest alone (most people do not make this much money from salaries or commissions).

Bonds are difficult to understand because different words and terms are used to mean the same thing.  Here are a few key terms to know:

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Coupon means the amount of interest the issuer is obligated to pay.  Coupon also means nominal yield. 

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Current Yield is the annual return expressed as a percentage of the actual amount invested.

The coupon/interest/nominal yield does not change.  But imagine a scenario where you buy a bond that once cost $1,000, but is now $800.  Even though the bond is priced for less (or selling for a discount), the coupon/interest/nominal yield of 8% will remain the same ($80 per bond).  Yet, you paid less for it because someone wants to sell it before it matures.  Consequently, your current yield is higher ($80 divided by $800) at 10%.  The buyer of the bond gets the best deal in this case.

Now, imagine you are the bondholder, you purchased it for $1,000, and now you need to sell it.  It is purchased for $1,100, $100 more (a premium) than what you purchased it for.  The 8% coupon/interest/nominal yield decreases ($80 divided by $1,100) and the current yield is 7.3%. 

Are you still with us?  Good.  Lastly, imagine that you purchased the bond not at face value (that would be too easy of a calculation), but at a discount or premium and decided to hold the bond to maturity date.  How would you calculate the yield to maturity?  We’ll leave that for another time. 

A good bond (issued by an entity with a good credit situation) can provide you steady income if you hold the bond until it matures.  Sometimes people buy bonds issued by entities with a negative credit situation, with the promise of a higher interest rate payment for the risk you’re taking.  The greatest risk is that the issuer goes “belly up” and is unable to repay your principal.  Like all things in investing, do not let greed influence your decisions about where your money goes.  If the basics of pricing bonds is new to you, re-read and re-read this article or pick-up a book about bonds. 

Copyright © 2000, Marabella Books