Chapter 4-1 Introduction to Bonds

Bonds and bond funds can be very valuable to anyone that is worried about the security of their money and income production.  Bonds and bond funds can also aid and somewhat counterbalance the risk that happens with equity investing, in spite of prevalent market circumstances.  They can be utilized to fulfill a variety of investment alternatives.  Bonds and bond funds carry favorable circumstances, but they also have risk.

A bond is a loan that an investor offers to a corporation, federal agency, government, or other organization.  As a result, bonds are often times called debt securities.  Because bond issuers acknowledge that you are not going to loan them the money you worked so hard for without receiving payment, the issuer of the bond, referred to as the borrower, engages in a legal agreement to pay interest to you, the bondholder.

The bond issuer also acknowledges to pay you the beginning total loaned at the bond’s maturity date, though specific circumstances, like a bond being called, may account for compensation to be made sooner.  For the most part, bonds have a fixed maturity date, a particular date when the bond must be repaid at its face value.  Bonds are called fixed-income securities because bonds compensate you with interest based on a predetermined interest rate, also known as a coupon rate.

The number of investors buying bonds and bond funds has increased in recent years.  Comprehending bond fundamentals is very important to executing knowledgeable investment choices in this investment.  The more you understand now, the less apt you will be to carry out a choice that you will be dissatisfied with later on.

A bond’s term, or years until it matures, is predetermined when it is issued.  Bond maturities can extend from one day to a hundred years, with most bond maturities extending from one to thirty years.  Bonds are frequently indicated to as being short-term, medium-term, or long-term.  Typically, a bond that matures in one to three years is indicated as a short-term bond.  Medium-term, or intermediate-term, bonds are typically bonds that mature in four to ten years, and long-term bonds are those whose maturities are more than 10 years.  The borrower satisfies its debt obligation usually when the bond gets to its maturity date, and the last interest payment and the beginning total you loaned, known as the principal, are compensated to you.

Despite the fact that you may want them to, not every bond reaches maturity.  Callable bonds are common; they permit the issuer to call a bond prior to reaching maturity.  Call clauses are summarized in the bond’s prospectus, offering statement, and the indenture.  These are reports that describe a bond’s terms and conditions.  Even though firms are not officially obligated to report every call clause term on the customer’s confirmation statement, most do.

You generally get some call security for a portion of the bond’s life, for instance, the first three years following the bond’s issuing.  This signifies that the bond cannot be called prior to a certain date.  Following that, the bond’s issuer can repay that bond on the set call date, or a bond may be called repeatedly, signifying that the issuer may repay the bond at the particularized price at any time throughout the call period.  Prior to purchasing a bond, always find out if the bond has a call clause, and take into consideration how that might affect your portfolio investment approach.

A bond’s coupon is the yearly interest rate compensated on the issuer’s appropriated money, typically distributed semiannually.  The coupon is always connected to a bond’s face or par value, and is priced as a percentage of par.  For example, a bond with a par value of $1,000 and a yearly interest rate of 5 percent has a coupon rate of 5 percent ($50).

Let’s say you invest $10,000 in an eight-year bond paying 4 ½ percent per year.  If you retain the bond until it matures, you will get 16 interest payments of $225 each, or a total of $3,600.  This coupon payment is simple interest and there are two things that you can do with that simple interest- you can reinvest it or spend it.  A lot of bond investors depend on a bond’s coupon payments as a source of income, using the simple interest that they get.  By reinvesting a coupon, you allow the interest to earn interest, which is known as interest-on-interest, also referred to as compounding.  No matter what type of investment you choose, saving at regular intervals and reinvesting your interest income can change even small sums of money into big investments through compounding.  Consider the following graphic that illustrates the payout structure of this bond.

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As you can see an initial investment of $10,000 produces 16 semi-annual coupon payments of $225.  The initial investment is returned in conjunction with the final coupon payment producing a one-time payment of $10,225.

Accrued interest is the interest that accumulates every day between coupon payments.  If you sell a bond prior to its maturity or purchase a bond in the secondary market, you will probably receive the bond between coupon payment dates.  If you’re selling, you have the right to the amount of the bond, in addition to the accrued interest that the bond has made until the sale date.  The buyer pays you for this part of the coupon interest, which is typically conducted by adding the total to the bond’s contract price.

Zero-coupon bonds are bonds that do not make regular interest payments.  They are sometimes referred to simply as zeros.  Rather than receiving an interest payment, you purchase the bond at a discount from the face and then receive the face value when the bond reaches maturity.  For example, you might pay $3,500 to purchase a 20-year zero-coupon bond with a face value of $10,000.

Zero-coupon bonds are issued by federal agencies, financial institutions, municipalities, and corporations.  The most well known zeros are Separate Trading of Registered Interest and Principal Securities (STRIPS).  A government securities dealer, financial institution, or government securities broker can turn a qualified Treasury security into a STRIPS bond.  The interest is stripped from the bond.  An attractive characteristic of STRIPS is that they are non-callable, which signifies that they cannot be called to be repaid if interest rates go down.  This mitigates the risk that you will have to compromise for a lower return rate if your bond is called.

The disparity among the reduced total that you pay for a zero-coupon bond and the face total you later get is the attributed interest.  This is interest that the IRS takes into account to have been compensated, even if in reality you have not received it.  Even though interest on zero coupon bonds is distributed at maturity, the IRS requires that you pay tax on this income every year, the same way you would on interest you got from a coupon bond.  A number of investors avoid paying the attributed tax by purchasing municipal zero-coupon bonds in their home state, or by buying corporate zero-coupon bonds that have a tax-exempt condition.

Although most bonds are fixed-rate bonds, there is a class of bonds called floating-rate bonds, also known as floaters.  Floaters have a coupon rate that is set regularly, or floats, utilizing an outside amount or sum, such as a bond index or foreign exchange rate.  Floaters provide security against interest rate risk, since the fluctuating interest coupon favors to aid the bond in keeping its existing market value as interest rates fluctuate.  Accordingly, their coupon rate is typically less than that of fixed-rate bonds.  Since a floating bond’s rate goes up as interest rates rise, they are likely to be utilized when interest rates are rising.  The majority of floater coupon rates are typically changed more than once a year at set times, often quarterly or semiannually.  Floating-rate bonds are distinct from variable rate or adjustable rate bonds, which change their coupon rate less often.  Floating and adjustable-rate bonds may have limitations on the highest coupon reset rate and the lowest coupon reset rate.

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