Many people get confused witht the numerous bond products available. This article attempts to simplify this process into easy language for all to understand.
Bonds, put simply, are instruments of debt. When a government, municipality or company needs money they try to raise it by getting investors to lend it to them. In return for this privelage, they promise to repay the entire debt back to us on a specified date. Interest payments will be made bi-annually, at a specified interest rate. Although this is simple enough, there are certain things that a savvy bond investor needs to know before jumping into the bond market.
Most bonds are offered through brokers in brokerage firms. There is a vast array to choose from, but regardless of the type, all can be analyzed in the same way.
Par
Par refers to the price of an individual bond. The price of the bond depends upon current interest rates. A bond offering 5% interest, at a time when new bonds are being offered at a rate of 4%, will experience more demand due to the higher interest rate. As a result the price or par will be higher. If a bond is offering only 3% interest and the interest rates on new bonds is being offered at 4%, then you can expect a bond to be offered below par.
Each par price represents one bond. One bond represents $1000 worth. So if you see that the par for a bond is listed as 100.00, that means the cost of 1 bond will be exactly $1000. If the par is listed at 103.45, the cost of 1 bond will be $1035.45. If you want 50 bonds at 103.45, which represents $50000 worth, you will be paying $51725.00. It is important to note that although you're paying more for the bond, the actual value of this bond if held to maturity will be only $50,000.
The extra cost is due to the higher interest rate being offered in comparison to other comprable bonds. If par, on the other hand is listed at 97.00, then the cost for 1 bond of $1,000, will be only $970. If the bond is held to maturity, you will get back the actual value of the bond which is $1,000. In this scenario, you have made $30 from the time of purchase to the time of maturity.
Interest
5% interest on a $10,000-dollar investment, will mean we'll get $500 interest a year, payable in 2 installments of $250, every 6 months. The months you get paid can be figured out based on the maturity date of the bond. If the bond becomes mature in June, then interest will be payed both in June and December, which is 6 months later.
When purchasing bonds, look at the yield listed for the bond, instead of income. Although the amount of income is something you have to determine for yourself, there still will be different prices for bonds that seem to be offering the same interest rate. There are many reasons for this, usually due to demand for that specific bond type.
Yield
Yield is what your bond is actually costing you. Yield is a calculation of all of your interest payments over time plus the actual cost of the bond. You may notice that some bonds, with a higher par, will actually yield you more. That's because you will get more income from this bond over time than you would with another, even though its initial costs are higher. The rule of thumb should be buy a bond with the highest yield that you can afford at the rate you want. Certainly don't overpay. Decide what it is you want to spend and see what's available.
See the Wall Street Journal's Lifetime Guide To Money for more information.
