9 Essential Terms And 5 Risks You Must Understand To Succeed Bond Investment

9 Essential Terms And 5 Risks You Must Understand To Succeed Bond Investment
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Bond Investment Tips

Investing in bond is a great option to protect your asset.  One of the bond investment tips is that the best application is to make bond investment part of your investment portfolio up to 25% in order to counteract the loss during the recession.  The long-term investment of bond alone is not recommended because it won’t provide a proportional growth with inflation.  Investing in equity and locking it up is the best option for the like-time investment.  The stock market suffered great depression and recessions but eventually recovered from down time.  This is consistent with value investing standing point.

If you ever wonder investing in bond, here are some basics bond investment tips.  A bond is a debt obligation with face (par) value typically $1,000.  The bond can be purchased and sold once it hits the secondary market.  When you trade bonds, brokers normally won’t charge commission but may differentiate purchasing and selling (ask and bid) price to make markups.  Three types of bonds are commonly available, treasury securities, municipal bonds, and corporate bonds.  The explanations for these bonds are listed in this link.

 

Bond Investment Terminology

Bond Investment Tips:
There are many terms regarding bond investment.  Here are some of basic terms you should know before you start bond investment.

1. Face Value / Par Value

This is the initial unit price of bond by issuer.  Typically $1,000 per bond.

2. Principal

This is the amount that you invest to buy a bond and the price may change just like stocks.

3. Primary Market

It means buying a bond directly from the issuer and it can be company, municipal, U.S. Treasury department, or any other entity legally able to issue a bond.  Normally unless you have hundreds of millions of dollars of capital, you are buying a bond in the secondary market.

4. Secondary Market

This is where you normally buy your bond.  It means you are buying bonds from financial brokers who trade a number of bonds and other products.  Once the bond is issued by the issuer, it goes to the secondary market and able to be traded freely just like stocks.  The price of bond changes all the time; it can go higher and lower based on a number of reasons.  The factors affect the bond prices are bond rating, financial situation of issuer, and/or demand in the market.

5. Premium

If the bond is traded at higher price (>$1,000) than the face value, the bond is called premium.  The yield percentage is going to be lower than the coupon rate.  The principal goes higher than the face value mainly because the market thinks it is less risk.

6. Discount

If the bond is traded at lower price (<$1,000) than the face value, the bond is called discount.  The yield percentage is going to be higher than the coupon rate.  The discount takes place when the bond is considered to be higher risk.

7. Coupon Rate

The coupon rate is a percentage of principal for periodic fixed payment.  The bond with coupon will pay fixed amount of payment every designated term, normally twice a year.  If you own a bond with face value $10,000 with QTY 10 and coupon rate of 2%, then bond payment per year is $200.  Therefore, if you buy this bond, you will receive coupon as an interest.

8. Yield (Market Rate)

What is the difference between coupon rate and yield?  Here is the explanation.  The yield is an interest rate based on the designated coupon rate and the current market value of principal or the price you paid to buy a bond.  Since the price of bond changes all the time once it hits the market, the interest rate (yield) of bond investment also changes.  If you buy a bond with quantity of 10 at the price of $11,000 with coupon rate of 3%, that bond is 10% premium (Face Value = $1,000 x QTY of 10).  Therefore, you spend $11,000 to buy the face value of $10,000 bond.  The coupon payment is 3% x $10,000 = $300.  The yield is coupon divided by the amount you spent to buy or current market value of this bond = $300 / $11,000 = 2.727%.

9. Zero Coupon

It’s possible that the bond does not offer coupon payment.  This is an example of zero coupon and sold at discount price and the investor earns capital gain up on maturity.

 

The Risks of Bond

Bond Investment Tips:
Although the risk of investing in bond is lower than investing in common stock, You need to understand the risks of bond investment.

1. Inflation

Since it’s fixed income investment (except some other variable rate bond), the same amount of coupon will be paid every designated term (normally twice a year).  As economy grows, inflation (CPI growth) takes place and if the bond yield (interest rate) is lower than the annual CPI growth rate, then your purchasing power or inflation-adjusted wealth of your investment will be lower than the last year.  Suppose, you have a bond principal of $10,000 with coupon rate of 2%, the bond pays $200 every year.  Assuming this $10,000 represents all of your asset, your asset is grown by 2% for this particular year.  If the CPI growth for this particular year is 2.5%, then the value of everything else has been risen by 2.5%.  Thus, your purchasing power is down by 0.5%.  You can observe CPI data at Bureau of Labor Statistics consumer price index website.

2. Price Fluctuation

The bond price fluctuates all the time.  Normally it’s not as volatile as stocks but you may still lose or earn money by the price change of bond principal.  If you buy a bond at premium, which is higher than the face value, and sell at the lower price than the price you bought, you will have a capital gain loss.  This is particularly imminent for bonds with high premium since they tend to pay higher coupon, which instigates demand for purchasing.  For the bond with premium, the price of bond is likely to go down as it approaches to the maturity date.

This means the investors are willing to sell rather than buy since they don’t want to hold it until maturity date.  Because the face value is the principal payment rather than the price that the investors paid .  Therefore, longer you hold the bond with premium, higher the risk is going to be.

3. Financial Situation of Business

Although the bond is a debt obligation, there is a possibility of default (inability to pay interest or bankruptcy of issuer).  If the issuer goes out of business, it liquidates its assets on the balance sheet to pay liability (including bond investors’ principal) back as much as they can.  Depending on the difference between asset and liability, it’s possible that the bond holders only get the partial amount back.  The investors may want to check the issuer’s financial statement before they buy and while they are holding the bond.  The government bonds such as treasury securities have very slight chance of default (can you imagine the federal government is going out of business?).  The market value (price) of government bond fluctuates very small amount and it is considered to be very low risk investment in contrast to corporate bonds.

4. Downgrading

The major rating institutions publish bond rating such as AA, AAA, or BBB.  If the rating is down, it suggests that the financial status of business is not really bright.  This often causes a drop of market value.  One of bond investment tips is to observe the financial status of entity.  This helps to forecast the future expectation of financial management.

5. Callable

Some bonds are callable, meaning the issuer may buy back bonds before the maturity date and normally at just above the face value (around 2-3%).  You should check whether the bond is callable or not before you purchase and the bond summary typically shows it.  The call normally takes place when the price of bond goes higher than expected.  This suggests that the investors are willing to pay higher principal for this bond’s coupon rate.  Then the issuer starts thinking that this bond can maintain enough demand for purchase even there is lower coupon rate.  The issuer calls bond and recovers all the bond in the market and often sells same bond at lower coupon rate to save money.

Takeaway

The above is a summary of bond investment tips.  There are essential things that you need to understand before investing bonds.  If you follow these bond investment tips and blend your portfolio with major common stocks consist major indices, you can increase the chance of increasing your asset.

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