What is a Bond?
Bonds fall into the “fixed income security” asset class. When you buy a bond you are lending your money to a government or company for a certain period of time. In return, they promise to pay you a fixed rate of interest at certain times and to repay the “face value” at the end of the bond’s term (its “maturity date”). A bond’s term can range from one to thirty years. The “face value” (or par value) is the value the bond was issued at. Interest payments are based on the face value. The annual interest rate paid is called the bond’s coupon. For example, a bond that has a face value of $1,000 and an interest rate of 5% would pay coupon payments totaling $50 a year.
How Risky are Bonds?
Bonds tend to offer better rates of return than cash equivalent investments (such as a Guaranteed Investment Certificate or Treasury Bill), because you’re taking on more risk by lending out your money for a longer period of time. Very high-yield bonds are sometimes called “junk” bonds. They offer much higher rates of return, but they can be very risky and have no guarantees that you will get your money back.
Income tax is another important consideration. Interest, dividends and capital gains are all treated differently for tax purposes and that will affect your return from an investment. Your financial adviser can help you assess your financial needs, goals and tax situation.
Remember in investing, the higher the potential return, the higher the risk. There’s no such thing as a high return, risk-free investment. If you want higher returns, you have to be comfortable with the risks that go along with them.
How are Bonds Priced?
Understanding why bond prices rise and fall can be complex. There are many different types of bonds available with different maturity dates and interest rates. A financial adviser can help you make decisions about buying and selling bonds that suit your risk tolerance and investment goals. They can also provide you with research from companies that rank bond risk. It is important to understand the risks involved before you buy or sell any investment.
How could I make money?
Holding bonds until their maturity date. You will not only get your initial investment back, but you will also receive interest payments while you hold the bond.
Selling a bond for more than you paid. When interest rates go down, the value of a bond would normally go up – by selling the bond in this situation, you may get more than you paid for it. You will also have the interest payments you received while you held the bond.
How could I lose money?
Selling a bond for less than you paid. When interest rates go up, the value of a bond would normally decrease. If you have to sell your bond early for some reason, you could lose money.
The bond issuer is not able to pay you the interest payments. If the company is dissolved, bondholders have a right to a portion of the company’s remaining assets. They rank behind tax authorities, employees and creditors but ahead of preferred and common shareholders. You may not get back all the money you originally paid.