But what exactly is a bond, and how does it work as an investment? Whatever your age, understanding how bonds works and how they should fit into your portfolio is crucial.
A bond is a type of investment in which you as the investor loan money to a borrower, with the expectation that you’ll get your money back with interest after your term length expires.
Bonds are a type of fixed-income investment, which means you know the return that you’ll get before you purchase. Bonds can be issued, meaning put up for sale, by the federal and state government as well as companies.
Bonds are one of two ways you can invest in a business. The other is to buy a company’s stock. While bonds represent a debt investment – the company owes you money – stock represents an equity investment, which means you own part of the company.
When you buy a bond, you’re lending money to the entity that issued the bond, whether that’s a company or a government. Since you’re lending, that means you’re entitled to collect interest. When the bond matures, you’ll get back the money you paid for the bond, known as the principal or the par value, and you’ll also get interest on top of it.
When you’re shopping for bonds, you’ll be able to see each bond’s price, time to maturity and coupon rate. The coupon rate is the annual money you’ll receive, expressed as a percentage of the principal that you pay to buy the bond. Coupon rates for new bonds hover around the market interest rate.
So, if you purchase a two-year bond with a par value of $1,000 and a coupon rate of 4%, then you would earn $40 in interest for each year of the term and $80 in total interest. Most bonds will pay out interest twice a year on what are called coupon dates. This is fairly straightforward, but things get more interesting when we think about reselling these bonds on the secondary market.
The bond market is sensitive to fluctuations in the interest rate. What do we mean by “the” interest rate? There are lots of different interest rates, for things like home mortgages and credit cards, but when someone refers to “the interest rate” or “interest rates” in a general way, they’re referring to the interest rate set by the Federal Reserve. This is also known as the federal funds rate.
The Fed uses its power to buy and sell Treasury Bonds to affect interest rates. When the Fed sells Treasury Bonds, it’s taking money that would otherwise circulate in the economy. Cash becomes more scarce, which makes borrowing money relatively more expensive and therefore raises interest rates. Interest rates are the cost of borrowing money. The interest rate that the Fed decides on as a target has a knock-on effect on other interest rates, including your mortgage rate and the rates on bonds.
When the general interest rate goes up, the price of existing bonds falls. In other words, interest rates and bond prices have an inverse relationship. Think of it this way: If interest rates rise, new bonds that are issued will have a higher interest rate to reflect this change. If you go to sell a bond that has the old, lower interest rates, you’ll have to lower its price to get anyone to buy it. That’s because the opportunity cost of holding your old, lower-coupon-rate bond has risen. Potential buyers will think, “Why pay $1,000 for a bond paying 4% when I could pay $1,000 for a bond paying 5%?”
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