Bond Investing Basics
A bond is a debt security that corporations and governments use to borrow money. Investors who buy bonds are looking for income with low risk. You'll find a lot of bonds in the portfolios of retirees who want to protect their equity and derive income. Younger investors also buy bonds to balance growth-oriented stocks with income-producing bonds that reduce the overall risk in their portfolios.
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Types
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There are three broad categories of bonds. Treasury bonds are issued by the federal government and are the lowest risk type of bonds. Municipal bonds (often called "munis") are issued by state or local governments and are popular with many investors because, although they have lower yields, they are normally exempt from taxes. Corporate bonds are issued by companies to raise money for capital investment and growth. Bonds are issued for a specified period of time (called the maturity) up to 30 years and occasionally even longer. At maturity, the issuer must redeem the bond. Very short term bonds (less than 9 months) are typically not considered part of the bond market. Rather, these are the securities that make up the "money market" and are primarily bought by money market funds, rather than bond investors.
Function
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Bond investing basics begin with how bonds work. When a bond is issued, it has a face (or par) value. Corporate bonds usually come in $1000 and $5000 denominations, as do municipal bonds. Treasury bonds may have face values of $10,000 or more, although some types are issued at lower denominations. It's important not to confuse the face value with price. The face value is the amount the bond issuer must repay when the bond matures. However, bonds are traded much like stocks. Bond prices rise and fall in response to market forces and are rarely the same as the face value. Each bond has a "coupon rate." This is a fixed sum the bond owner is paid each year. For example, a $1000 bond might have a coupon rate of $100 (equal to 10% of the face value of the bond).
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Price and Yield
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A bond's yield depends on its price and coupon rate. The coupon rate is constant, so if the price falls below the face value ("selling at a discount"), the percentage return rises. For example, a $1000 bond with a $100 coupon that is selling for $800 has a yield of $100/$800 or 12.5%. The same thing happens in reverse if the bond's price rises above the face value ("selling at a premium). You've paid more for the bond, so the percentage yield is lower.
Significance
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The most important factor influencing a bond's price (and thus its yield) is the prevailing interest rate at any given time. If interest rates rise, due to inflation or some other cause, bond prices will fall as investors seek to securities with higher yields. When interest rates fall, bond prices tend to rise as investors are attracted to the relatively higher bond yields.
Risks
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Bonds, like any other securities, carry some risk. Long term bonds are higher risk because there is greater uncertainty about conditions 20-30 years in the future than over the next 2-3 years. For corporate bonds, risk is also related to the company's fortunes. Investors looking for a maximum of safety should seek out "blue chip bonds." These are bonds that carry a top rating by services that assess bond risk like Moody's or Standard and Poor's. Low rated bonds ("junk bonds") carry much higher risk the company will not be able to repay the borrowed money when the bond matures. In general junk bonds have higher yields to compensate for the added risk. Investors should keep in mind that at maturity, the bond will be redeemed only for face value, regardless of inflationary effects over time. The safest bonds are US Treasury bonds. They do have somewhat lower yields as a result
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