Understanding Bonds
Riswandi
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Understanding Bonds
Santri Alat - UNDERSTANDING BONDS - There are certain things you must understand about bonds before you start investing in them. Not understanding these things may cause you to purchase the wrong bonds, at the wrong maturity date.
The three most important things that must be considered when purchasing a bond include the par value, the maturity date, and the coupon rate.
The par value of a bond refers to the amount of money you will receive when the bond reaches its maturity date. In other words, you will receive your initial investment back when the bond reaches maturity.
The maturity date is of course the date that the bond will reach its full value. On this date, you will receive your initial investment, plus the interest that your money has earned.
Corporate and State and Local Government bonds can be ‘called’ before they reach their maturity, at which time the corporation or issuing Government will return your initial investment, along with the interest that it has earned thus far. Federal bonds cannot be ‘called.’
The coupon rate is the interest that you will receive when the bond reaches maturity. This number is written as a percentage, and you must use other information to find out what the interest will be. A bond that has a par value of $2000, with a coupon rate of 5% would earn $100 per year until it reaches maturity.
Because bonds are not issued by banks, many people don’t understand how to go about buying one. There are two ways this can be done.
You can use a broker or brokerage firm to make the purchase for you or you can go directly to the Government. If you use a brokerage, you will more than likely be charged a commission fee. If you want to use a broker, shop around for the lowest commissions!
Purchasing directly through the Government isn’t nearly as hard as it once was. There is a program called Treasury Direct which will allow you to purchase bonds and all of your bonds will be held in one account, that you will have easy access to. This will allow you to avoid using a broker or brokerage firm.
Holding bonds vs. trading bonds
If you buy a bond, you can simply collect the interest payments while waiting for the bond to reach maturity the date the issuer has agreed to pay back the bond's face value.
However, you can also buy and sell bonds on the secondary market. After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter your interest payments and face value won't change.
But if you buy and sell bonds, you'll need to keep in mind that the price you'll pay or receive is no longer the face value of the bond. The bond's susceptibility to changes in value is an important consideration when choosing your bonds.
Bond terms to know
The language of bonds can be a little confusing, and the terms that are important to know will depend on whether you're buying bonds when they're issued and holding them to maturity, or buying and selling them on the secondary market.
Coupon: This is the interest rate paid by the bond. In most cases, it won't change after the bond is issued.
Yield: This is a measure of interest that takes into account the bond's fluctuating changes in value. There are different ways to measure yield, but the simplest is the coupon of the bond divided by the current price.
Face value: This is the amount the bond is worth when it's issued, also known as "par" value. Most bonds have a face value of $1,000.
Price: This is the amount the bond would currently cost on the secondary market. Several factors play into a bond's current price, but one of the biggest is how favorable its coupon is compared with other similar bonds.
Choosing bonds
Several factors may play into your bond-buying decisions.
Maturity & duration
A bond's maturity refers to the length of time until you'll get the bond's face value back.
As with any other kind of loan like a mortgage changes in overall interest rates will have more of an effect on bonds with longer maturities.
For example, if current interest rates are 2% lower than your rate on a mortgage on which you have 3 years left to pay, it's going to matter much less than it would for someone who has 25 years of mortgage payments left.
Because bonds with longer maturities have a greater level of risk due to changes in interest rates, they generally offer higher yields so they're more attractive to potential buyers. The relationship between maturity and yields is called the yield curve.