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What is a Bond?
By Blue Collar Investment,
BlueCollarInvestment.com
When you purchase a bond issued by a corporation or government, you are actually loaning the issuer money. The bond specifies the amount of the loan, interest rate, how often the issuer will make interest payments to you and the date the principal of the loan must be paid in full (maturity date).
For example, you might purchase a $10,000 bond with the following characteristics:
- 8% annual interest rate.
- Interest paid in two semiannual payments.
- Bond matures in 2016, when you would get back your original $10,000 principal.
Many investors choose bonds when they want a source of current income while seeking to preserve their capital. There are many kinds of bonds, such as U.S. Treasury, U.S. Agency, corporate, municipal and zero-coupon bonds.
Bonds often are referred to as "fixed income" investments because they typically offer fixed interest payments and principal repayment. A bond may be rated by an independent rating service, such as Standard & Poor's or Moody's Investment Services, Inc. Both companies use letter grades ranging from triple-A (the highest) to D (in default) to evaluate a bond's credit quality.
Bond prices are directly affected by interest rates. Typically, when interest rates fall, bond prices rise and vice versa. That sounds contradictory to many people because a bond comes with a fixed interest rate and a fixed principal amount. The following example, which is for illustrative purposes only, may help clear up any possible confusion:
In 1996, Investor A bought a bond from Company A as follows: |
In 1997, Investor B bought a bond from Company A, but interest rates went down: |
|
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In this example, Investor A's bond is worth more money than Investor B's because Investor A is getting a higher annual interest rate for the same $10,000 investment. If another investor wanted to buy Investor A's bond, he would likely have to pay more than $10,000 because its annual interest rate is higher than the going rate at the time. If interest rates went above 8%, Investor A's bond would be worth less than $10,000 because an investor could purchase a new $10,000 bond that pays a higher rate.
