Bonds are a type of investment that results in an investor lending money to the bond issuer in exchange for interest payments. They are one of the most important investments available for those who follow an income investing philosophy.
With the different options available to you, including municipal bonds, commercial bonds, savings bonds, and treasury bonds, you need to know which is right for your unique situation as well as the risks.
All investments carry some degree of risk. Generally, the higher the risk, the higher the return. Thus, lower levels of risk result in lower returns, meaning that you may give up the potential for higher returns in favor of a safer investment.
You want to learn how to invest in bonds, but don’t know where to start? Here are some of the factors you should take note first if you’re thinking about investing in bonds.
The price of a bond refers to variables like interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds usually sell at or close to the same level (100% of the face value). However, traded bonds in the secondary market vary in price in response to changing factors such as interest rates, credit quality, general economic conditions and supply, and demand. When the price of a bond increases above its face value, it is selling at a premium, while it is selling at a discount when a bond sells below face value.
Bonds pay interest that can be fixed, floating or payable at maturity. Fixed rate bonds have an established interest rate when the bonds are issued with periodic interest payments, typically twice a year.
Some issuers, however, prefer to issue floating-rate bonds, the rate of which is reset periodically in line with the then prevailing interest rates on Treasury bills, the London Interbank Offered Rate, or other benchmark interest rates.
A bond’s maturity refers to the date on which the investor’s principal will be repaid. Generally, bond terms range from one year to 30 years.Term ranges are often categorized. For short-term, maturities range to at least 5 years; Medium-term maturities range of 5-12 years, while long-term maturities can range beyond 12 years.
Generally, short-term bonds are comparatively stable and safer because the principal will be repaid sooner and so usually offer lower returns. Thus, longer-term bonds typically provide greater overall returns to compensate investors for greater pricing fluctuations and other market risks.
There are two typical types of redemption features such as call provision and put provision.
Call provision allows the issuer to redeem the bonds at a specified price and date before maturity. Before buying a bond, always determine if there is a call provision. If there is, be sure to consider the yield to call as well as the yield to maturity. Meanwhile, put provision gives the investor the option to sell the bond to the issuer at a specified price and date prior to maturity. Typically, investors exercise a put provision when interest rates have risen so that they may then reinvest the proceeds at a higher interest rate.
Some corporate bonds, known as convertible bonds, contain an option to convert the bond into common stock instead of receiving a cash payment. Convertible bonds have provisions on how and when the option to convert can be exercised and at what price. Convertibles offer a lower coupon rate because they have the stable return of a bond while offering the potential benefit of a stock.
PRINCIPAL PAYMENTS AND AVERAGE LIFE
Priced and traded bonds are based on their average life rather than their stated maturity. For example, in purchasing mortgage-backed securities, it is important to consider that homeowners often prepay mortgages when interest rates decline, which may lead to an earlier than expected return of principal, reducing the average life of the investment (prepayment risk). If mortgage rates rise, the reverse may cause homeowners to prepay slowly and investors may find their principal committed longer than expected (extension risk).
The yield is the return earned on a bond, based on the price and the interest payment received. Yield is also known as a percentage. Sub-units of percentages are called basis points. There are three types of bond yields: current yield, yield to maturity, and in some cases, yield to call.
Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond interest payment of its price. Yield to maturity is the total return received by holding the bond until it matures, while yield to call is the total return received by holding the bond until it is called or paid off before the maturity date at the issuer’s discretion (refer to call provision).
Part 2 is now available! Learn more about the Factors to Consider in Bonds Investment.
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