In exchange for lending money to the issuer, an investor receives an income by holding the bond, which includes the principal of the loan, as well as a fixed or variable interest payment.
A bond is a tradable asset that can be bought or sold once it has been issued.
The value of a bond is calculated by taking the present value of all future interest and principal payments. It can be calculated using the Discounted Cash Flow method.
Present value is the value of money today that is mathematically equivalent to all future payments. The present value is obtained by using a prevailing interest rate, also known as the discount rate.
The higher the discount rate, the lower the price of the bond; the higher the interest rate, the lower the present value of the bond.
Bonds can be divided into two general types: fixed income and variable income.
- Fixed-income bonds pay a fixed amount of interest regardless of the prevailing market rate. Examples of fixed-income bonds include treasury bonds, corporate bonds, and mortgage-backed securities.
- Variable-income bonds are subject to change in interest payments in response to market conditions. Examples of variable-income bonds include floating-rate notes and convertible bonds.
The interest rate affects the value of bonds in an inverse relationship. If the interest rate increases, the value of the bond decreases, and if the interest rate decreases the value of the bond increases.
When the base rate of interest increases, the coupon rate held on a bond becomes relatively less attractive, so in order for bond investors to purchase the bond the price of the bond must be reduced. Conversely, when the base rate of interest decreases, the coupon rate offered by bonds becomes relatively more attractive, and the price of the bond rises.
Bonds are generally a low-risk investment and provide a source of reliable income from interest payments. They have the potential for greater returns than more conservative investments such as stocks or cash. bonds also have the potential to preserve capital by in hard times due to their long-term, fixed rate of return.
Additionally, their need for long- term financing for governments and companies mean bonds are less likely to be affected by short-term market volatility, making them a dependable option for some investors.
Bonds are not without risk. Investors should research the bond issuer, understand the risk of non-payment, and consider the potential for default risk before investing in a bond.
Inflation can have a negative impact on the value of bonds, because their fixed return payments may not keep up with rising prices. Also, changes in interest rates can also change the value of a bond.
Credit risk can cause the failure of a bond issuer to make its coupon payments. Thus, investors must evaluate the quality of the issuer before investing in a bond.
If you want to buy bonds, your can either choose to buy newly issued bonds or buy bonds on the secondary market. Here are some options :
- From your broker: Similar to stocks, you can buy bonds directly from your broker. Bonds are tradable assets, so you can buy them from other investors looking to sell those bonds.
- Using an ETF: Instead of buying bonds directly, you can buy bonds via Exchange-Traded Funds (ETFs). This will allow you to buy a certain basket of bonds and get exposure to some industries or countries. This is a good option to get immediate diversification. You can buy bond ETFs directly via the funds, or from your online broker.
- Directly from the government: You can for example buy US bonds directly from Treasury Direct. This option will allow you to avoid additional fees such as brokerage.