Bonds
Bonds are loans that companies and governments issue to raise money. And like all loans, the borrower (the company or government) pays interest to the lender (the investor who purchases the bond).
Most bonds pay interest, in regular installments, over the life of the bond. Which is why bonds are often called "fixed-income" securities. Then, when the bond matures, the company returns your initial investment to you.
Other bonds, like Canada Savings Bonds (CSBs) don't make regular installments. Instead, the interest and theprincipal are returned to you all at once (usually when the bond matures).
All About Bonds
When bonds are first issued by companies, they are usually sold to investors for a price that's very close to the face value. After the initial issue, bonds are bought and sold OTC (over the counter). That means that they're bought, sold, and traded by banks, brokerage houses, and investment dealers. If you wanted to buy a bond, you would generally go through a stockbroker. But, bonds don't trade on stock markets.
When you buy a bond through a broker, its price and its potential returns are based on the following:
- the number of bonds available at the time you place your trade
Like other commodities, bonds are affected by the laws of supply and demand. If there are more people selling bonds than buying them on a given day, the price may decrease.
- the level of current interest rates
Bonds that are offering higher rates usually trade for higher values than bonds with lower rates.
- the bond's term
When it matures, or comes due. A 10-year bond will usually have a higher interest rate than a 5-year bond to compensate you for lending your money for a longer period of time.
- the bond issuer's credit rating
This is the likelihood that the issuer will be able to pay back the money it borrowed when the bond matures (the day the loan is to be repaid). Bonds from less creditworthy issuers offer higher interest rates to compensate you for taking on the additional risk.
Government bonds usually have the highest credit ratings, because they have the lowest risk of defaulting on their obligations. But they also tend to have lower coupons.
With most bonds, the more money you have to invest, the better the price you can get. Think of it as a volume discount.
Making Money with Bonds
Investors can make money with bonds in two ways.
- buy the bond and hold it to maturity
When you lend money, you get paid interest and that's your return. You'll get back the money you lent as long as the borrower doesn't default on the loan.
- sell the bond at a profit before it matures
If the price of the bond rises and you sell it, you get a capital gain - the profit you make on the sale of an investment.
A bond's growth potential can range from modest to significant, depending on how stable interest rates are.
Remember, as long as the borrower doesn't default, you'll get back the money you lent. So, the value of the bond may go up and down over the time that you own it, but as long as you don't sell it before its maturity, you will get all your money back.
Bond Mutual Funds
You'll need to consult your financial advisor, but overall, bond mutual funds can be a smart way for investors with average-sized portfolios to participate in the potential of the bond markets.
After all, you can't even buy most bonds for less than $1,000. At that price, it would take a lot of money to purchase a portfolio of bonds, and it could take a lot of time to manage it.
In a bond fund, the fund manager pools your money with the money of others and purchases a number of different bonds, in denominations that provide more favourable interest rates. And, you might be able to buy into that pool of bonds with as little as $25 each month. Think about it. For just $25, you get access to a diversified portfolio of professionally managed bonds.
|
