How to evaluate bond issues and interest rates
When simplified, investment markets can be divided into two types: equity and debt. Equity investments are purchases of shares in a company and represent partial ownership of the company. Shareholders may or may not receive annual dividends. Debt investments, on the other hand, represent a loan to the company with the corresponding return plus expected interest. A bondholder is entitled to periodically scheduled interest payments. Debt investments are considered slightly safer than stocks, but there is risk associated with any investment.
Debt investments are commonly known as bonds. Bonds can be issued by federal, state, and local governments, as well as corporations. There are pros and cons to either. For example, if you invest in a federal bond issue, the interest income you receive from that investment is generally not subject to state and local taxes. Similarly, interest income from the issuance of state and local bonds is generally not taxed at the federal level. Interest income on corporate bonds is taxed everywhere.
It is a good idea to get an education about interest rates before investing in debt instruments. In the United States, the Federal Reserve Bank (or, the “Fed”) sets interest rates. They do this at a meeting held every six to eight weeks where the national economy is assessed. Then they decide what to do with interest rates. This decision is based on many factors, but mainly the rate of inflation that is being experienced.
If inflation rises, the Fed can raise interest rates. This makes the money supply (in the form of loans) a little tighter and harder to come by, which in turn curbs inflation. If there is no or very little inflation, interest rates will probably stay where they are. If there is deflation or a slowdown in the economy, the Fed can try to stimulate it by lowering interest rates, allowing more people to borrow, thereby stimulating the economy.
The reason you need to know what’s happening with interest rates before investing in bond issues is because bond prices are directly related to the interest rates currently available. In general, if interest rates are rising, bond prices are falling and vice versa. Of course, this means almost nothing if you intend to hold the bond until maturity. This is only noticeable if, like most bond investors, you tend to hold it for a shorter time, selling it before maturity. Therefore, if you sell a bond before maturity during a period of rising interest rates, the value of the bond may be less than it was when you bought it.
The main characteristics of a bond issue that you need to know are:
Coupon Rate: This is the interest rate you will be paid on this loan. You should also know when it is paid. This is usually once or twice a year on specified dates.
Maturity date: is the date on which the loan becomes due and payable. On that date, the company will pay back the principal you loaned them.
Call Provisions: Some bonds have the right of the borrower to repay the loan proceeds early. Some cannot be called. Those that are callable are usually returned at a higher price than you originally paid when the early option is exercised. Note that when a bond issue is callable and interest rates are falling, the company will often find it economically advisable to buy back your bond with the proceeds of a new bond issue at the new lower rates.
The biggest risk in bond investing is that the issuer goes out of business. This is why federal bonds are so popular; there is virtually no chance of the federal government going out of business! Federal Treasuries are among the safest investments you can make. Corporate bonds, however, are a different story. Any company can stop trading for various reasons. If you have an investment in a company’s bonds when this happens, your investment is worthless almost immediately. However, bondholders have priority over shareholders and will be paid first. Senior bondholders can even claim physical assets when the company is liquidated.
Bonds are a pretty safe good investment as long as you keep these risk factors in mind. A good mix if corporate, federal and local government bonds are advised. Even throwing in some junk bonds with high interest rates could be profitable. Diversification reduces risk, even in the bond market.
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