Investing in Bonds

Stock prices are guided by earnings. When a company’s gains increase through a period of time, the price of stocks of the company also are increased.

Reaction of prices of bonds under certain economic events are mainly different to prices of stocks. Prices of bonds generally decrease when the news about the economy are good and increase when negative. An understanding about these characteristics of bonds could explain the phenomena.

Bonds features

 A bond is a negotiable debt security under which the issuer borrows money and in exchange agrees to pay fixed amounts of interests during a specific period of time, and besides gives back the total amount of the principal when the bond reaches maturity.

The principal is the net value (par value) of the bond that generally is $1000 per bond.

A bond is similar to an IOU. Bonds also have certain similarity with the Certificates of Deposit (CDs) and savings accounts. Investors who deposit money in CDs (or savings accounts) are in effect a loan to banks.

Banks pay the investor interests over their deposits and later repay them the principal when CDs reach maturity. Equally, bond investors make loans to the issuer (corporation or government). This process turns them into creditors, not in owners, as in the case of investors in common stocks. In return, the issuer pays regularly a specific amount until maturity date of the bond.

Virtually, bonds have a maturity date, time in which the issuer gives the investors  back the face value of each bond. The main difference between the three, savings accounts, CDs and bonds is that investors can sell their bonds to others in the secondary market before the bonds reach maturity. Savings accounts and CDs cannot be sold to other investors.

Take into account that CDs in amounts larger than $100,000 can be sold before reaching maturity, make from it a very profitable investment.

Bonds are negotiable IOUs opposite to savings accounts and CDs in amounts smaller than $100,000, and issuers of these bonds pay regularly a fixed amount of interests y repay bondholders its principal on the fixed maturity date.

These regular payments of interests make bonds a good investment for investors that search fixed amounts of incomes and be given back its principal when at maturity date. Bonds in general have similar characteristics. A bond has a face value, also known as par value which is the bond amount that is repaid at maturity. The bonds par value is almost always $1,000 with very few exceptions. The par value is the amount under which interests to pay is determined.

For example, if a bond is bought when issued at a price of $1,000, the investor is buying such bond at its par value. At bonds maturity date the investor receives $1,000 per owned bond.

When bonds are issued a maturity date is fixed, and will be the date bondholders will receive the par value of their bonds. Maturity date is the date in which the issuer of the bonds takes away the bonds from the market and pays the bondholders its par value. Bonds’ maturity dates can be established from a day to 100 years.

Bonds with maturity of one year or less from the time of issuance are referred to as short-term bonds or debt. Bonds with maturity of one year to ten years are referred to as intermediate bonds or intermediate notes.

The long-term bonds are issued with a maturity of at least ten years and commonly up to 30 years. Disney Corporation and some other corporations have issued bonds with a maturity of 100 years, but this does not generally occur. Bonds have two types of maturity. The most common one is a term bond in which all bonds of a determined issue mature on the same date.

A serial bond has different dates of maturity within the same issue. The coupon rate of a bond determines the annual amounts of interests paid by a bond which generally is determined in a percentage over the face value.

If the coupon rate is of 5% the issuer of those bonds agrees to pay $50 (5% x $1,000, the face value) in annual interest per bond. Many bonds pay interests each semester, the bondholders will receive $25 per bond every six months. Some bonds have adjustable or floating interest rates.

Let’s suppose that last year you purchased a bond with a coupon rate of 5% when the market rates were also of 5%, and you paid $1000 per bond. This year the markets’ interest rate raised to 6%. What price would you receive if you sold such bond? Obviously, new investors wouldn’t pay $1,000 for a bond with a performance of 5% when they could buy new bonds with an updated coupon rate of 6% for each $1000. Due that new investors would expect to get at least a 6% from a bond that would be sold at a lower price than $1000 (a discount) in order to be more competitive against current bonds.

Equally, if the markets interest rates fall under the coupon the rate, the new investors will be willing to pay more than $1000 per such bond. That is how prices of bonds are vulnerable to the market interest rates, as to other factors that will be discussed later on.