In our last Investing Basics article, we talked about stocks. Today we’ll talk about bonds. Later, we’ll look at mutual funds, options, futures, and short-term savings options.
What Is a Bond?
As I explained in the post about securities, a bond represents debt. Bonds are long-term debt contracts issued by corporations and governments. The bondholder has a right to receive interest plus the return of the bond’s face value at maturity (when the bond is due). Face value just means the stated value of the bond.
If you purchased a $1,000 bond paying 10% interest in semiannual payments, you’d get $50 every six months. When the bond matures, you’d get your $1,000 back.
Interest Rate Changes
Investors can choose to buy or sell bonds before they mature. Depending on whether the current interest rate is higher or lower than the bond’s interest rate, investors will pay less than or more than face value. If the current interest rate is higher, investors would pay less than face value for a bond because they could get higher returns by purchasing new bonds. If the current interest rate is lower, investors would pay more than face value because they can’t get a higher return from new bonds.
Changes in interest rates do not matter if you hold the bond to maturity because you’ll get the stated interest rate plus the face value back. You don’t care if interest rates change from month to month because you’ve already locked in your interest rate. And you don’t care if the current value of your bond changes from month to month because you’re going to keep your bond until it matures (and you get your money back). Changes in interest rates only matter when you might sell the bond before it matures. In this case, the value of a bond can increase or decrease similar to the way stock prices change. (However, changes in bond prices are directly tied to changes in interest rates.)
Bonds are considered safer than stocks because you’re taking less risk. If a company liquidates or goes bankrupt, bondholders get paid back before stockholders because they have a contract with the company. Because they’re less risky, bonds have historically returned less than stocks over the long term.
A certain type of bond called a “convertible” bond lets you convert the bond into a specific number of stock shares if you choose. These bonds provide interest (although usually a lower rate than regular bonds) while giving you a chance to participate in the appreciation of the company’s stock.
Finally, some bonds are “callable”. This simply means that the issuer can choose to repay the bond before it matures. This can be good or bad depending on your situation. There are several aspects to these bonds that we can’t cover here, so we’ll look at them later when we get into more advanced investing topics.
In the next article, we’ll look at mutual funds. Make sure you sign up for free updates to Provident Planning if you want to learn more!