A bond is a loan made to a company (or government entity). Just as with a house loan, the
loan is made for a specified period of time, Unlike a house loan,
the loan is not repaid over time. Instead, the company will pay a
fixed amount of interest on the loan during the period and then repay
the loan all at once at the end of the period. For example, a bond
with a par value (loan value) of 1000 and a coupon of 5% would
pay $50 per year, or $25 every six months. When the bonds mature,
the person holding the bonds would be paid $1000 plus the final $25
During the life of the bond, it will be freely traded on the market and the price will
fluctuate. An advantage is that one can make both interest and a
capital gain from bonds. For example, if an investor bought the bond
listed above when it was trading for $500 and then held it to
maturity, he would receive both the interest payments , at an
effective rate of 10% for him, and $1000 when the bond matured. He
would therefore make a $1000 capital gain.
While it varies by company and term, bonds are generally safer than bonds. The reasons
are that the bond pays a fixed interest amount, meaning that a return
is generated even if stock prices are going nowhere, and no matter
what the price does, one can regain one’s investment by holding the
bonds until maturity. As with anything, however, there are risks.
Here are the main risks of corporate bonds:
Default: Obviously the primary risk with a bond is that the company that issues the bond
will be unable to pay and default on the bond. When this occurs,
sometimes the company will issue shares fo stock to repay part of the
loan, sometimes the company will repay the loan but at a later date,
and sometimes the company will just default and not pay. In general
when a company defaults on a bond the investor should expect to get
little or nothing back.
Interest Rate Rises: Because bonds are primarily bought for the interest they pay they are
very sensitive to changes in interest rates. For example, if banks
start paying higher interest rates, because a bank account is less
risky than a bond, many investors will sell their bonds and invest
their money in the bank. Because of this, the price of bonds will
decrease, causing their interest rates they pay to increase (remember
that bond interest rates go in the opposite direction as the price of
the bond). b]Buying bonds at periods like the present time, where
interest rates are rock bottom and only likely to go up, therefore is
especially risky. On-the-other hand, buying bonds when interest
rates are very high and most likely to go down is a sound strategy.
As interest rates decrease the price of the bond will go up. This
will provide income in addition to the relative high interest rate
that will be locked in when buying the bond.
Early Call: If interest rates are sufficiently low many bonds will trade
above their par value. This is because investors will go to bonds in
order to increase the amount of interest they make when bank accounts
are paying nothing. Many companies have call provisions that allow
then to repay the bonds early. If interest rates are very low they
may well call the bonds, paying the par value, and then issue new
bonds at a lower rate. this is much like a person refinancing their
home. When this happens, if you’ve bought at above par value you
will lose the difference.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.