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In the lemonade example, the grandmother bought a bond when she
lent $100 and contracted to get it back with 5% interest in a year. When you invest in
bonds, the bond you buy will show the amount of money being borrowed (face
value), the interest rate (coupon rate or yield) that the
borrower has to pay, the interest payments (coupon payments), and the deadline for paying
the money back (maturity dates).
One way to invest is to lend your money to others. In this case,
it is called "buying a bond." If you buy a bond with a $10,000 face value and a 15-year maturity, and you
hold it for fifteen years, you will get $10,000 back plus interest payments, normally
every three or six months.
The main difference between bonds and CDs or T-bills is that, with bonds, you get paid
a higher interest rate (about 2% more), but you wait longer to get your money back (ten to
thirty years). With CDs and T-bills, you get your money back in three months to two years.
There are pros and cons to bond investments.
Advantages
 Bonds give higher interest rates compared to
short-term investments.
Bonds are less risky compared to stocks.
Disadvantages
Selling bonds before they’re due may result in
a loss, a discount.
If the issuer of the bond declares bankruptcy,
you may lose money.
One of the risks of investing in bonds is a default, which
occurs when the issuer of the bond fails to make payments. To keep investors informed
about the chance that a bond will default, companies such as Standard & Poors (S & P) and
Moody’s give ratings to bonds. The higher the rating, the lower the
chance that a bond will default. S & P grades bonds from AAA, AA, A ... to D.
Moody’s rates bonds from Aaa ... to C. A strong company such as Disney gets AAA or Aaa. AAA or Aaa
means the chance of Disney defaulting on a bond is very small.
The low rated bonds, such as bonds issued by USAir,
are called junk bonds. A junk bond is issued by a weak company that may have trouble
paying its bills. To compensate the risk an investor takes in purchasing a junk bond, it
pays high interest rates (10 to 15 percent).
There are three types of bonds: Treasury bonds (T-bonds), municipal bonds (munis), and corporate bonds.
The U.S. government is the biggest seller (issuer) of bonds in
the world. Although our government runs up $5 trillion of debts, (money that is borrowed
to run its budget), and spends more than 15% of its tax income to pay the interest on the
debt, Uncle Sam’s bonds are safe. Of course, the interest rate on T-bonds is lower
than those of corporate bonds. Generally speaking, the
safer your money is, the less interest you will get paid.
The kinds of bonds that kids are likely to buy are called U.S. Savings Bonds.
These can be bought with as little as $25. Grandparents are known for giving savings bonds
as gifts to their grandchildren. For more information about Treasury Bonds call
1-800-USBONDS or click
here.
Also, click here for Savings bonds information.
Muni bonds
are bonds sold by municipalities to raise money to build public facilities such as
schools, roads, water supplies, and stadiums.
The advantages in buying munis is that the interest payments are free from federal and
state income taxes. However, the downside is that, unlike Uncle Sam, local governments can
have money problems, and sometimes may not be able to make interest payments. For example,
when Orange County in California
filed bankruptcy in 1994, some of the bonds the county issued were in default. Check the
bond rating before you invest.
 Corporate bonds are bonds
that are issued by corporations such as Disney,
IBM, and General
Electric. These bonds work the same as munis except that their interest
payments are taxable. Corporate bonds also receive bond ratings from S & P and
Moody’s.
When you keep a bond until its maturity, you get paid the bond’s face value, the
same price you paid for the bond, plus the yearly coupon payments, which is a fixed amount
based on the interest rate.
Bond originally issued:
Face Value : $1,000
Current Interest Rate: 10%
The bond’s yield reflects interest rate: 10%
Yearly bond payment (coupon payment): 1,000 × 10% = $100 (fixed)
If you sell the bond prematurely, the bond's price can change, depending on the current
interest rate and the fixed coupon payment. For example:
Case #1 (Premium)
Current Interest rate: 8%
Yield : 10% - 2% = 8%
Yearly bond payment : 1,250 × 8% = $100 (fixed)
Bond price = $1250 (You make $250)
If the current interest rate goes down to 8%, the bond's yield also reflects the 8%.
Moreover, when the interest rate goes down, the bond's price must go up in order to keep
the coupon payment fixed at the original issue amount. In this case, since the coupon
payment must stay at $100, the bond's price goes up to $1250. It is sold at a premium
(more than the face value) when interest rates go down. Depending on the interest rate at
the time, the bond has to sell at a premium or discount to compensate for the change of interest rate.
Conversely, the bond price will come down if current interest rates go up. Then, you
will sell the bond at a discount (less than the face value).
Case #2 (Discount)
Current Interest rate: 13%
Yield : 10% + 3% = 13%
Yearly bond payment : 769 × 13% = $100 (fixed)
Bond price : $769 (You lose $231)
Bond prices and current interest rates are published daily in the financial sections of
major newspapers. You can also find bond quotes on the Internet.
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