Bond Investment
Basics
Unlike the stock market, there's no central exchange for trading
bonds. Nevertheless, the process is almost as easy as trading
equities (stocks).
Acquire, if you haven't already, a brokerage account - such as
the ones from a full-service broker or one of the many on-line only
trading accounts. In some cases, it'll be necessary to phone rather
than place an order over the Internet.
Ok, that's the easy part. Now, for the slightly more difficult
aspects.
Bonds have a purchase and sale price, but also an interest rate.
Purchasing one entitles the bearer (bondholder) to payment of the
principal at maturity (when the principal must be repaid in full),
and twice-annual interest payments.
Price Movements and Interest Rates
Just as with stocks, bond prices vary. The initial price (and
the interest rate they pay) is set at the time they're issued. As
soon as seconds later they may be worth more or less than that. One
of the major factors influencing bond price movements is general
market interest rates.
If interest rates on real estate loans, large corporate bank
loans, savings instruments such as certificates of deposit (CD)
fall after the bond is issued, the price of that bond will tend to
rise.
Common sense reveals the reason. Purchase a 5 year bond at
$1,000 that pays 7%, comparable (let's suppose) to that offered by
a similar-risk 5-year CD. Six months later, interest rates fall to
6%. (A larger than normal drop for that period, but not unknown.)
You now hold an instrument that pays more in interest than a
competing investment. Yours will command a higher price, if you
choose to sell.
(Specifically how much they tend to rise or fall, based on the
amount of rate change, over what expected period and other factors,
is a complex topic we leave for elsewhere.)
Bonds trading 'over 100' are said to be trading at a premium and
bonds 'under 100' at a discount. The terminology refers to: 100%
over or under the initial price. For example, a $1,000 bond (face
value, i.e. initial issue price) currently selling for $1,100 is
trading at a premium. (By, 10% in this case, since $1,100-$1,000 =
$100 and $100 is 10% of $1,000.)
Risk
Bonds, like any other investment, entail risk. Though
bondholders have priority over shareholders (owners of company
stock) in case of bankruptcy, if there's no money to pay position
in line is unimportant.
Most bonds are relatively low risk, at least in that they do
repay bondholders the principal. Low risk tends to correlate with
low return, however. Fortunately for the average investor several
long-standing, well-respected bond rating agencies exist. The most
well-known are Standard and Poor (S&P) and Moody.
These two companies rate bonds according to highly technical
analyst-calculated formulas, but the result is relatively simple: a
sliding scale of 'very low risk' AAA (or Aaa – Moody), to 'very
high risk' CCC or lower (so-called junk bonds).
As with any investment, the investor should do considerable
homework - investigating earnings projections, likely legal
entanglements, outstanding amount of debt and other factors -
before buying bonds. Remember, you're granting a loan. You'd like
to earn interest on the loan and you want the principal to be
repaid on time.
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