When You Purchase a Bond or Bond Funds; What Happens
Investing in bond funds or bonds are two different entities. When you purchase a bond, you are loaning your money to a corporation or to the government.
In exchange for loaning your money, you will receive the promise of regular interest payments. The bond will also be given a maturity date.
When the bond matures, you will be given your principal investment back. This will include several years’ worth of interest on that principal.
You can use a bond to live off the interest (although, in such a case, you would need to have invested quite a bit of money).
Alternatively, you could reinvest the interest, or use the bond for the purpose of balancing out a stock portfolio. This would work, because bonds are generally income investments, and stocks are generally growth investments.
Individual Bonds or Bond Funds as Income Investments
Income investments give you interest, and growth (or equity-stock) investments give you capital gains investment returns, if you have chosen your investments wisely. Therefore, usually when stock prices are up, bond prices are down, and vice versa.
This is one reason stock investors add bonds or bond funds to their portfolio. As the stocks go down the bonds go up and can balance out the portfolio’s bottom line.
Many people think that because bonds pay interest, they are 100% safe, because you can never lose your principal investment. This is not true!
The price of a bond (which is separate from the paid interest of a bond) can fluctuate. You can lose your principal if the price of your bond were to fluctuate to nothing (zero).
"There is an Important Difference Between Stocks and Bonds" -Lois
This is where bond ratings come in: there are high-yield bonds, and there are high-quality bonds. You must know the difference between the two, before you start to place your money into bonds.
Bond Ratings – Some Are Called “Junk”
The higher the interest rate of a bond, the lower that bond is rated— this is known as a high yield bond. The lower a bond is rated, the higher the interest will be that is paid on that bond.
This is why some financial advisors recommend that you buy short-term bonds, so that your bond can “mature” before its price decreases.
The highest-yielding bonds are usually the lowest-rated, high-yield bonds are called “junk bonds”. These are rated “C” by ratings services.
On the other hand, the lower the interest rate of a bond, the higher that bond is rated—this is known as a high-quality bond. High-quality bonds, which usually do not have high yields, are generally rated “A” or above by investment rating services, such as “Moodys”. There are several bond
rating services.
RATING DEFINITION’S: S&P MOODY’S
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Highest quality and grade. Prime. Maximum safety. AAA Aaa
Bonds which are judged to be of the best quality. They carry the smallest degree of investment risk. The obligor’s capacity to meet its financial commitment on the obligations is extremely strong.
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High quality. High grade. AA Aa
Bonds which are judged to be of high quality by all standards and only differ in small degree to the highest graded bonds. The obligor’s capacity
to meet its financial commitment on the obligations is very strong.
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Upper medium quality and grade. A A
Bonds which possess many favorable investment attributes and are
to be considered as upper-medium-grade obligations. They are somewhat more susceptible to the adverse effects of changes in circ*mstances and economic conditions than obligations in higher rated categories. However, the obligor’s capacity to meet its financial commitment on the obligations
is strong.
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If you are an individual investor who is purchasing a bond, it is usually
best to stick with a bond that has a rating of “A” or better. (see the “Summary,” at the end of this article).
BONDS DIFFER, BASED MOSTLY UPON WHO ISSUES THEM:
- Government-issued bonds are called Treasury Bonds.
- Corporation-issued bonds are called Corporate Bonds.
- State- or Local-issued bonds are called Municipal Bonds, or “Muni’s,” for short; this type of bond is generally exempt from all state and
local taxes.
Individual Bonds Versus Bond Funds
Purchasing an individual bond can be an overly complex endeavor, and generally requires a large sum of money at hand. To fund even a single bond, you will often need at least $10,000 (but sometimes less).
Institutions, such as pension plans and insurance companies, will often purchase bonds. But they also have teams of people who can thoroughly analyze which bonds to buy, along with when it is best to buy—and sell—them.
Some Investors Use Bond Funds to Balance Their Portfolio -Lois
Individuals don’t have this kind of investigative power, and it would require an individual with a lot of individual bonds. Therefore, you need a lot of money—for your individual “bond portfolio” to be considered diversified.
An alternative would be to invest in bond funds, in Treasury Bonds or Muni’s. You can invest in bond funds, which is significantly different from an individual bond.
The obvious difference is that an individual bond is just what its name implies—i.e., one bond—while a bond fund is a collection of individual bonds. Before you invest in bond funds, start a series of simple ways to save money first.
Another big difference is that, while an individual bond will mature, a bond fund never matures. (Remember, you can cash-in on your bond when it matures and get your principal investment back).
If you invest in bond funds, it is best to look for one whose individual bonds have average, short-term maturities. As investors get older the tendency to invest in bonds more than stocks, because the fluctuation in prices tends to be lower. Disclosure: I do invest in bond funds, as well as other investments.
SUMMARY
- There are high-yield bonds and high-quality bonds.
- High-yield bonds pay higher interest rates but are not very stable; the highest yielding bonds are known as “junk bonds.”
- High-quality bonds pay lower interest rates but are usually more stable than high-yield bonds.
- Bond prices fluctuate: a low-quality, high-yield junk bond’s price could even fluctuate to zero; this would cause you to lose your principal, should you have invested in such a bond.
- The highest-quality bonds are rated “Aaa” and “AAA,” by Moody’s and Standard and Poor’s rating services, respectively; and the lowest-quality bonds are rated “C” (junk), by the same two services
- To decrease your chances of landing a bond with a price that fluctuates too low, it is best to buy short-term bonds.
- There is big difference between individual bonds and bond funds; one important difference is that, while individual bonds mature, bond funds never mature.
Lois Center-Shabazz | Course Delta Agency
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