| Bonds - Turning Debt Into Fixed Income | | | | market may only be willing to pay you $950. |
| | | | |
| Bonds are an often overlooked component of a | | | | But what most commonly has an impact on a |
| balanced investment portfolio. Bonds are | | | | bond's market value are changes in interest |
| almost always safer, and in certain economic | | | | rates. Although the actual bond's interest |
| cycles, bonds typically outperform the stock | | | | rate is fixed, prevailing interest rates |
| market. Although they're not right for | | | | elsewhere in the economy can radically alter |
| everyone, a solid understanding of bonds is | | | | the value of a bond. |
| important for every serious investor. | | | | |
| | | | If interest rates go up, the value of bonds |
| The Basics | | | | go down, and vice versa. This is because no |
| | | | one would be willing to pay $1000 for a bond |
| Whereas stocks represent ownership in a | | | | with a seven percent coupon when they could |
| company, bonds represent the company's debt. | | | | buy a new one with a nine percent coupon for |
| When you buy a bond directly from General | | | | the same price. |
| Motors, you are essentially lending the | | | | |
| company money. For this reason, bonds are | | | | Government Debt |
| sometimes referred to simply as "debt." | | | | |
| | | | U.S. government bonds are the safest of all |
| If you buy a bond directly from its issuing | | | | fixed income securities. This is because all |
| company, the amount you pay for the bond is | | | | government debt is backed by the full faith |
| called its "face value" or "par value." Most | | | | and credit of the U.S. government. |
| bonds have a face value of $1000. | | | | Essentially, this means that the federal |
| | | | government can't go bankrupt, because it |
| Bonds also have a stated "term to maturity." | | | | controls the printing presses. |
| This could be one, five, ten, or thirty | | | | |
| years, or any other duration imaginable. | | | | Municipal bonds are debt issued by cities and |
| Disney actually issued 100 year bonds not | | | | counties. They aren't quite as safe as U.S. |
| long ago. | | | | government securities, but they do have one |
| | | | major advantage - they are virtually exempt |
| Every six months until maturity, bonds pay a | | | | from all levels of taxation. As a result, |
| set amount of interest called the "coupon | | | | municipal securities typically pay a lower |
| rate". This term comes from the old days when | | | | pre-tax coupon rate than federal government |
| people literally tore off and mailed in | | | | debt. |
| coupons that were attached to their bonds in | | | | |
| order to be sent back interest payments. Upon | | | | For people in high income tax brackets, the |
| maturity, the issuers of bonds must repay | | | | tax savings are enough to offset the lower |
| their holders the face value of the bonds.. | | | | coupon rate, and thus municipal securities |
| | | | are often great investment vehicles for the |
| If, for example, the coupon rate is seven | | | | wealthy. |
| percent on a $1000 face value bond, this | | | | |
| means that the bondholder will receive | | | | Safe Investment T.I.P.S. |
| interest payments of $35 every six months | | | | |
| ($70 per year) until the bond matures. | | | | If you're a really risk-averse investor, then |
| | | | for you, TIPS may be the greatest thing the |
| The amount of interest paid every six months | | | | government ever invented. TIPS, or Treasury |
| doesn't change, and for that reason bonds are | | | | Inflation Protected Securities, are a unique |
| sometimes called "fixed income securities." | | | | variety of ultra-safe fixed income government |
| | | | debt securities. |
| Corporate Debt | | | | |
| | | | TIPS typically pay a very low interest rate, |
| Corporate bonds are the best known, and | | | | but they mature at the inflation adjusted |
| riskiest of all bonds. If a company goes | | | | equivalent of the original face value. |
| bankrupt, for example, its bondholders may | | | | Furthermore, the semi-annual coupon rate is |
| receive a mere fraction of their investments. | | | | also adjusted every six months. |
| Credit rating agencies, such as S&P, | | | | |
| assign ratings to fixed income securities | | | | For example, investing $100,000 into 20-year |
| ranging from AAA to D. | | | | TIPS may promise a coupon rate of just 2.5 |
| | | | percent. This means that you would receive |
| Bonds with credit ratings of BB and below are | | | | semi-annual interest payments of $1250. |
| considered junk bonds, meaning that their | | | | |
| issuing companies face a realistic | | | | However, if inflation were measured at three |
| possibility of defaulting on their debt. | | | | percent the first year after you purchased |
| | | | your TIPS, the new coupon rate would be |
| Changes in a company's credit rating effects | | | | 2.575 percent, resulting in semi-annual |
| the value of its debt. Although the face | | | | interest payments of $1287.50. What's more, |
| value always remains the same and the issuing | | | | the $100,000 face value of the TIPS would |
| company always redeems bonds at their | | | | appreciate to $103,000. |
| original face value, bonds can also be traded | | | | |
| between investors before they reach maturity. | | | | After 20 years of inflation adjustment, the |
| | | | face value of your TIPS will have multiplied |
| These trades are said to take place on the | | | | by several fold. Although you sacrifice the |
| "secondary market." For example, if the | | | | opportunity to realize outsized gains, TIPS |
| credit rating of a company were lowered and | | | | are the ultimate in safe investments, as even |
| you wanted to sell one of its bonds that you | | | | inflation risk is avoided. |
| paid $1000 for, your fellow investors in the | | | | |