The bond market always seems so confusing
to almost everyone. It does look to be upside down.
Why is it so?
When an investor buys a bond that matures
in 20 years he plunks down his cash, say $10,000,
and each quarter (or annually or as agreed) the
bond issuer sends him a check for the interest.
If it was 6% the bond holder will receive $600
annually until the twentieth year when the bond
issuer returns his $10,000. Very simple.
But suppose the bond owner suddenly has a
need for cash and must sell the bond. The bond
issuer is not required to take back the bond
until the 20th year. The investor must find
someone to buy that bond now. Of course, the
new owner will then receive the interest
checks. The bond is still worth $10,000 at
maturity so it should bring $10,000 on the open
market. Or will it?
Not necessarily.
If the interest rate market has fallen to
3% for this type of bond then it should sell for
an amount that will yield $600 on an amount of
money at 3%. Now that bond is worth $20,000
($600/.03X100). Conversely, if the interest
rates have increased to 9% the amount received
from the premature sale of the bond will fall
to $666 ($600/.09X100). The bond holder gets
less for the bond than the face amount, but the
new owner will receive the full amount at
maturity. The amount received from the sale is
directly related to the current yield for bonds
of the same quality.
As the interest (yield) goes up the principal
amount the bond holder can realize from the
sale of the bond goes down. As the yield drops
the bond can be sold for more than the face
amount, but will still bring the face amount at
maturity. The amount of time to maturity is not
being considered; however, the closer to
maturity the more value the bond will have.
When an investor buys a bond he wants two
things: safety of principal and return on his
investment (ROI). There is no consideration for
appreciation of capital. There are many types
of bonds and they are rated in term of safety.
The number one safety is the U.S. Treasury
Bond. It is where almost every foreign
government invests its money even beyond their
own government securities. There are various
rating agencies with the best known being
Moody’s.
Bonds are rated from AAA to junk with the
latter being speculative with the chance they
could default meaning you lose your money. Even
better graded bonds such as municipals are
questionable, but these and other bonds can be
bought with insurance to guarantee you will get
your money back.
Most financial advisors recommend that
portfolios contain a higher percentage of bonds
as people get older. That is for the investor
to decide.
Each person must determine risk versus
guaranteed return.
Al Thomas' book,
"If It Doesn't Go Up, Don't Buy It!"
has helped thousands of people make
money and keep their profits with his simple
2-step method. Read the first chapter at
http://www.mutualfundmagic.com and discover why
he's the man that Wall Street does not want you
to know. Copyright 2006 All rights reserved.
