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A company like General Motors has two ways to raise money:
it can issue stock (which means it can sell shares
of its ownership), or it can issue bonds.
Bonds are loans you make to the company and in return
you receive a specific interest rate for a specific period
of time.
A key difference between stocks and bonds is that with bonds
you are assured of the return (not the case with stocks).
That is why bonds are also known as fixed-income
investments.
Financial
consultants often tell people to buy bonds as a way to diversify
their investments, or as income-producing investments during
retirement.
Bonds
work a lot like certificates
of deposit
or share certificates.
When you buy
a bond, you agree to pay a certain amount of money (the face
value), leave it in an account for a certain amount of
time, and the issuer promises to pay you back on a
particular day (the maturity
date) at a predetermined
rate of interest (the coupon).
Here’s
an example: you
buy a bond with a $1000 face value, a 5% coupon and a
10-year maturity. You
collect interest payments totaling $50 (5% of $1000) in each
of those 10 years and at the end of 10 years, you collect
your $1000.
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Unlike certificates, bonds are not insured and are more risky because they
are backed by individual corporations.
You usually get a higher interest rate on corporate
bonds (over certificates and most government-issued bonds) because
you are willing to take on an increased risk.
Some
bonds (like some certificates) are callable,
which means the company can decide to pay them off early and
avoid future interest.
For instance, if you buy a bond with a 5 percent yield
and after one year, rates drop and similar bonds are
yielding 4 percent, the issuer may decide to call your bond.
Bonds
usually don’t make as much money as the stock market or
other growth-oriented investments like real estate. However,
during terrible economic times such as the Great
Depression, bonds sometimes perform better for
investors. They are good investments when interest rates are
low and if the stock market is not performing well.
Bond
prices and yields vary based on interest rates, supply
and demand, credit quality,
maturity and dollar amount.
A general rule is that as interest rates go down,
bond prices go up and vice versa.
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It’s
important to do your homework (just as you would before
investing in a stock or
mutual fund) and check out a company and its industry rating
before purchasing its bonds.
Bonds
are rated as a measure of the company’s financial
stability and risk of defaulting (not paying back its loans)
by debt-rating agencies like Moody’s and Standard &
Poor’s. High-rated
bonds (Aaa, Aa, A, etc.) are less risky than low-rated ones
(Ba and below). Low-rated
bonds (called junk
bonds) typically pay higher
interest rates to entice you to take on more risk.
Bonds
can be issued for a period of months or even up to 100
years. Any kind of business can issue
them
– even rocker David Bowie issued “Bowie bonds.”
Companies can sell convertible
bonds which means the bonds can be converted into
stock.
People
can trade bonds on the bond
market, and this is where things get tricky.
The price of a bond can rise or fall, and that will,
of course, change its interest rate.
Say that you purchase a 20-year bond with a face value of $1000 and a coupon rate of 8%, earning you $80 a year and 8% yield. After three years, it can go on sale for $800, but still at 8% interest on the original $1000. The lower price is called the bond’s discount price. You will still earn $80 a year, but now your interest rate is 10%. If you pay a premium price of $1200, you’ll still earn $80 a year, but your interest
rate is now only 6.66%.
There are actually zero
coupon bonds sold at deep discounts from their face value so
they do not generate periodic interest
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payments. The return is realized at maturity. Bonds with a lower coupon rate will fluctuate more in price
than a higher coupon bond.
Zero-coupon bonds fluctuate the most.
Bond
market prices change every day.
They are listed in the financial pages of newspapers
typically like this:
Bond
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Cur
Yld
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Vol
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Close
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Net
Chg
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CompUSA
6-3/4 25 |
7.3 |
20
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92-3/4
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+1/8
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ILLBell
8-3/4 19 |
7.4 |
32
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113-5/8
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-7/8
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In
this example, the company issuing the bond is listed in the
first column. Immediately following is the interest rate paid by the bond
as a percentage of its par value, followed by the year the
bond matures. CompUSA bonds (maturing in the year 2025) are up from 6.75%
interest to 7.3%, but the price of the bond at the end of
this day was only $927.50 (compared to $1000 par
price).
In
the second line, Illinois Bell’s bond, maturing in 2019,
closed at 7.4% or down from 8.75%, but its price is up at
$1136.25, which is more than par (par is $1000).
If the corporate bond
world and its jargon make your head swim, you’re not
alone. Smaller,
do-it-yourself investors can now select and purchase
corporate bonds made available only to individual investors
(called
InterNotes
and Direct Access Notes) from your broker for a minimum
investment of $1,000.
Mutual
fund companies
buy and sell
bond
funds
in big quantities. When you work through them, you don’t really own a
particular bond but a share of the fund.
See what you learned.
Check out:
"From Junk
to U.S., Bonds That Is"
"Pay Attention
to Paying Interest" "The
Feeling is Mutual, Funds That Is" |
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