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If an investor is thinking of investing in bonds, the first rule is that a bond is nothing more than a debt instrument, a loan. Think of buying a bond like making a loan to a corporation, government, federal agency, or other organization. Bond issuers understand that investors will not invest without a full understanding of the offering. The bond is a legal agreement to provide the bond and its benefits under known and advanced information. The investor buys the bond, and the bond issuer agrees to the terms of the bond.
The term of a bond, the time until the maturity date, is established when the bond is issued. Bond maturities can vary from a concise period to 50 years or more. The borrower fulfills its debt obligation (pays the bond face value) when the bond reaches maturity. The final payment may include any unpaid interest and the original issue price of the bond.
Bond issuers often provide an escape clause in the bonds they issue, which allows the bond's issuer to pay the bond indebtedness off before the maturity date. This provision is known as the "call date" or callable. They can often change the rules when it is beneficial to them by installing a trap door; this is known as "callable." This feature allows the bond issuer to retire before it matures if interest rates favor the bond issuer. Interest general rates decrease, the bond issuer may use the "callable" feature of the bond; if interest rates increase, the bond issuer may keep the bond until maturity. This feature is a definite benefit for the issuer of the bond.
The amount of interest earned as a bond owner is dependent on what time during the life of the bond it was acquired. As an example, if you bought a new issue bond paying 5%, you would earn 5% as long as you owned the bond or until maturity.
But if the bond was purchased in the secondary market, earned interest would be lower or higher depending on how much was paid for the bond. If a lesser than face amount were paid, the received interest would be higher than the original interest; the opposite is then also true. If in the secondary market you paid less than face value, you bought it at a discount; if you paid more than face value, you purchased the bond at a premium, actually earned interest would be lesser than face value.
Consider this rule: Bond price and yield are inversely related: As the price of a bond goes up, its yield will be less.
Here are relevant terms to know when you consider owning bonds.
• Yield to maturity (YTM) is the interest rate earned by an investor who buys a bond at the original issue date at the market price and holds it until maturity.
• Yield to call (YTC) is the interest earned from the issue date until a bond is called. The bond issuer may redeem callable bonds before the maturity date. The actual date of a callable period is disclosed at the time the bond is issued. Bonds with a callable date have only one opportunity to "call."
There are fundamental risks associated with owning bonds. The most critical factor in owning bonds is fluctuation in overall general interest rates. When prevailing interest rates fall, the value of in-force bond prices rises, and when interest rates rise, bond prices fall. Interest rate risk is the risk that changes in interest rates in the U.S. or the world may reduce (or increase) the market value of a bond you hold. Interest rate risk—also referred to as market risk—increases the longer you keep a bond. In addition to market risks are Call Risks Failure Risks. The bond issuer can also fail and not make interest payments or repay the bond at the end of maturity.
Bonds will offer a rating based on their safety. An AAA rating would mean the bond issuer has the highest credit rating available. Lesser ratings such as B and C can still be stable investments, plus they will pay a higher interest rate and AAA. If a bond issuer begins to fail, the ratings can be changed as the credit rating drops. Bonds with a D or F rating may not be suitable investments for anyone other than speculators. Always ask for the bond rating and make sure you know its ability to meet its financial obligations.
You have numerous choices of types of bonds in which to invest. The difference between the bonds can be the safety of the bond and the interest offered. A good rule of thumb is; the higher rated bonds will offer the lowest interest rate. The opposite is also true; if the investor wants a higher interest rate, you may need to accept a higher level of risk.
Here are some classes of bonds available to you:
• U.S. Treasuries
• Municipal Bonds
• Corporate Bonds
• U.S. Savings Bonds
• Mortgage-Backed Securities
• International Bonds
• Miscellaneous Bonds
The financial industry offers information about bonds that can be very helpful: http://www.finra.org
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