Bonds explained

The bond market always seems so confusing to almost everyone. It seems to be upside down. Why is it so?

When an investor buys a bond maturing in 20 years, he puts his money down, say $10,000, and every quarter (or annually, or as agreed) the bond’s issuer sends him a check for the interest. If it was 6%, the bondholder will receive $600 annually until the twentieth year when the bond issuer pays back its $10,000. Very easy.

But suppose the owner of the bond suddenly needs money and has to sell the bond. The bond issuer is not required to redeem the bond until its 20th year. The investor now has to find someone to buy that bond. Naturally, the new owner will then receive the interest checks. The bond is still worth $10,000 at maturity, so it should be worth $10,000 on the open market. Or will it?

Not necessary.

If the interest rate market has fallen to 3% for this type of bond, then it should sell for an amount that will yield $600 on a 3% cash balance. Now that bond is worth $20,000 ($600/.03X100). Conversely, if interest rates have risen to 9%, the amount received from the early sale of the bond will fall to $666 ($600/.09X100). The bondholder gets less for the bond than the face amount, but the new owner receives the full amount at maturity. The amount received from the sale is directly related to the current yield for bonds of the same quality.

As interest (yield) rises, the principal that the bondholder can realize from the sale of the bond falls. As the yield falls, the bond can be sold for more than the face amount, but the face amount remains at maturity. Time to maturity is not taken into account; however, the closer to the maturity date, the more value the bond will have.

When an investor buys a bond, he wants two things: security of principal and return on investment (ROI). Capital growth is not taken into account. There are many types of bonds and they are rated for safety. Security number one is the US Treasury Bond. It’s where almost every foreign government invests its money, even beyond their own government bonds. There are several rating agencies of which Moody’s is the best known.

Bonds are rated from AAA to junk, the latter being speculative with a chance of default meaning you lose your money. Even better-rated bonds, such as municipal bonds, are questionable, but these and other bonds can be bought with insurance to guarantee you get your money back.

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Most financial advisors recommend that portfolios contain a higher percentage of bonds as people age. That is for the investor to decide.

Each person must determine risk versus guaranteed return.