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A bond is a debt obligation. The average bond investor will pay $1000 for a bond. The bond carries a fixed interest rate, over a fixed
period of time. An example is a 6.5% interest rate bond due in 10 years.
Bonds trade on a bond exchange, similar to
stocks on a stock exchange. Most bond investors are professionals, wealthy
individuals, or large institutions. Small investors normally invest in bond
mutual funds, to reduce individual risk (the fund will buy many bonds
from many different companies).
Bonds are less risky than stocks, but have lower returns than stocks on average. The biggest concern about bonds is Interest Rate Risk.
When interest rates go up in the economy, bonds go down in value. When interest rates go down in the economy, bonds go up. Many
investors will hold bonds the entire term, to lock in an interest rate for 10 years or so.
About Interest Rate Risk, bond prices tend to "match" prevailing rates.
If you buy a bond at 6.5%, and the current interest rate is 7.5%, then the price of your bond will have gone down ($65 interest on your bond
divided by the .075 current rate gets an estimated $867 market price of your bond). Thus, if interest rates are going up, long
term bonds should be evaluated carefully before buying.
Bond mutual funds are usually classified as short term (bonds maturing in 1-2 years), intermediate term (2-5 years), and long term (5-30 years). Generally, the shorter the term, the lower the interest rate risk. If interest rates are rising sharply, a 3 year bond may drop only 4% in value,
while a 15 year bond may drop 12%. Mutual funds will have bonds maturing at older interest rates, while buying bonds at current rates, which
reduces risk.
Often you may hear about the yield curve. The yield curve is a graph of interest rates. The vertical axis represents interest rates, and the
horizontal axis represents time. Normally, the greater the time, the higher the rate, so the yield curve most often slopes up from
left to right. A flat yield curve means short term and long term rates are the same, which generally means that short term rates must go down soon, or
that long term rates must go up soon (at the top or bottom of a business cycle usually). The
difference between short and long term rates is referred to as the inflation premium, as people are putting up money for a very long time and
are offered a higher rate to do this.
Bonds can have capital gains or losses, and interest. A capital gain or loss is when you sell a bond before maturity at a different
price than you originally paid (either at a profit loss). Interest is paid based on the terms of the specific bond you purchase, bi-annually for example. Bond mutual funds will distribute income (the interest from bonds) often monthly, and then once or
twice per year distribute capital gains (the profit from selling bonds). Please remember, such income is usually taxable, and your accountant should advise you on making such transactions.
A bond coupon refers to its interest rate. At one time, purchasers of bonds would actually clip off a coupon from a paper certificate, and redeem it a
bank or investment house every time interest was due. Today, people might state that a bond has a 7% coupon, and its simply the interest rate of
the bond.
Lastly, fixed income bonds are those normally guaranteed by the government and carry the least risk (and the lowest interest rate). Municipal
bonds or munis are issued by state agencies or cities and are often tax exempt (and also have a lower rate due to this). Bonds are rated
by investment companies, essentially from A to D, based on the credit worthiness of the company. A Junk Bond is one issued by a company that might default on its bond
interest payments, or even go into bankruptcy.
An average investor might have 25-50% of their money in an intermediate term bond fund, for diversifications reasons, and a
Certified
Financial Planner (CFP) can advise you on making such investment decisions.
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