The Basic of Bond investing
Bond investing basics are simple. When you buy a bond, the bond issuer – either a government or corporation – pays you an agreed-upon rate of interest known as the coupon rate. In addition, you get your original investment back when the bond reaches a maturity date. Before investing in a bond issue, you should consider several factors. Do you want to go long- or short-term? Normally, longer-term bonds pay higher interest than shorter-term bonds. However, monetary policy and inflation expectations vary with time, so sometimes the normal yield curve may flatten (meaning short- and long-term rates are equal) or invert (short-term rates are higher than long-term rates). When this occurs, it can be very hard to sell a long-term bond because investors can get the same or higher rate investing short-term.
People invest money in bonds and bond funds to earn a higher income in the form of interest or dividends (bond funds). That’s the advantage of bond investing. On the other hand, your not-real-savvy neighbor neglected to tell you the other half of the story. Bond investing always involves risks. Even the safest bond investment in the world, U.S. Treasury bonds, is subject to interest rate risk. Interest rates are at or near historical lows, which makes it tempting to chase higher interest income. A bond investment pays a higher rate of interest than you can get at the bank. But here’s the problem, the risk factor most folks know little about: a bond has a fixed coupon rate (interest rate) that never changes for the life of the security.
Longer term bond prices tend to be much more volatile than those that hold shorter terms. While price changes tend to increase at a diminishing rate, these long term bonds are much riskier, and as a result will promise much higher returns, which is what they are usually apt to do. Bond investments with longer terms tend to be much more susceptible to the interest rate risk simply because their interest payment future stream is long and does not traditionally match the current rates. What this means is that the bond price is going to more than likely adjust a great deal more as a means of compensating for the interest rate changes. If you are not fond of the interest rate risk associated with bond investments, it would be wise instead to invest in shorter term maturities. You should aim for maturities that are shorter in length than five years. You are going to want to stay away from 10 year and 20 year maturities, and you should absolutely aim to avoid 30 year maturities. 5 year bonds are much easier to hold to maturity than 30 year bonds, after all.
A convertible bond is another bond definition to look at. This is a bond that allows you to convert your investment into stock. The price of this when divided by the conversion price is the conversion ratio. In some cases a bond involving a different type of currency than what you are used to can be involved. This is where a Eurobond is taken out. A Eurobond is a bond that usually has no tax and is issued in a currency other than what you use. Several bond definitions you will need to consider involves how much you will pay. The ask and bid have already been discussed, but there are other bond definitions to watch for. For instance, there is the coupon, which is the annual interest percentage on your bond that you will have to pay. Also, there is the yield, which is the rate of return on your bond. This can be read through a yield curve, which is the pattern of yields on bonds that you may have. The modified duration can be considered, as it shows how sensitive a bond is to changes in its yield. This also relates to the volatility of the bond, which is the measure of the bond’s price movement over time. The convexity of the bond is also important to consider. This is the measure of the curve of the price of the bond and its yield in regards to a fixed income.
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