Investing in Bonds

Investing in Bonds

Bonds are a type of IOU. If an entity wants to raise money, one method of doing this is by issuing
bonds. When you purchase a bond, another entity (whether it is a corporation or the government)
owes you the money it borrowed, plus
interest.

To understand the purchasing of bonds
you must understand some basic
terminology:

*Bonds have maturity dates. When you
purchase a bond, you purchase it for a
period of time. The ending date is the
maturity date.

*Bonds are either issued through the
private sector (corporate bonds) or
through the public sector
(government bonds).

*When purchasing a bond, you might
purchase it at face value or you might
purchase it at a discount.

One of the most important concepts to know when investing into bonds is there is an inverse relationship
between interest rate and bond price in the secondary market.

Before investing into bonds, you might want to read the information on this website about the possible risks involved when
investing into bonds: https://www.investopedia.com/ask/answers/05/bondrisks.asp

Interest Rates and Bond Prices (Inverse Relationship)

Interest Rates Fall in the Primary Market and Bond Prices Rise in the Secondary Market (Inverse Relationship)

How to purchase a U.S. Treasury Security: https://www.treasurydirect.gov/indiv/research/indepth/tbonds/res_tbond_buy.htm

Here is an imaginary example:

Let's say you purchase a $1,000 one-year bond earning 3%. At
the end of one year, you would receive $30. Using the calculator
to the left, figure the present value of the bond TODAY.

Future Value: $1,000 (you receive your principal back in a year)
Interest Rate: 3%
Years: 1
Your answer: $970.87.
This means your interest $29.13 is equivalent to 3% when you
receive your $1,000 one year into the future.

Let's say you purchase a $1,000 one-year bond earning 5%. At
the end of one year, you would receive $50. Using the calculator
to the left, figure the present value of the bond TODAY.

Future Value: $1,000 (you receive your principal back in a year)
Interest Rate: 5%
Years: 1
Your answer: $952.38.
This means your interest $47.52 is equivalent to 5% when you
receive your $1,000 one year into the future.

Interest Rates Rise in the Primary Market and Bond Prices Fall in the Secondary Market (Inverse Relationship)

Future Value and Present Value

To understand this concept of "interest rates and bond prices
having an inverse relationship," you must understand that there
is a primary market and a secondary market for bonds.

Newly issued bonds are sold in the primary market. Once these
bonds are purchased in the primary market, the owner of these
bonds can sell them in the secondary market (the buying and
selling of bonds that have already been issued in the primary
market).

If newly issued bonds in the primary market have higher
interest rates relative to those bonds in the secondary market,
the only way the secondary bonds can be sold is if they are
sold at a lower price so the buyer can receive the same higher
interest rate that is offered in the primary market.

After looking at the short lesson to the left, scroll down to the
two lessons below that explains this in another way.

If you want to sell your bond in the market, you must lower your price on your 3% interest rate bond to $952.38 so that the
purchaser of your bond earns 5% interest on your bond. Your bond earning only 3% in the secondary market won't be purchased
if someone can purchase a bond earning 5% in the primary market.

Notice as interest rates go up in the primary market, the price of the bond goes down in the secondary market.

Let's say you purchase a $1,000 one-year bond at face value. This means you purchase the bond
for $1,000 and will continue to earn interest until the date of maturity. Let's say, though, you
purchase a $1,000, one-year bond at a discounted price of $950. This means upon maturity you
will be paid $1,000 or in essence $50 extra since you only paid $950 for the bond. Your rate of
return then is 5.26%. ($50 / $950 = 5.26%)

Here are some broad categories of bonds*

1) U.S. government bills, notes, and bonds
2) Mortgage-backed bonds
3) Municipal bonds
4) Corporate bonds (high-grade)
5) Junk bonds (low-grade)
6) Foreign bonds

Government bills, notes, and bonds

Mortgage-backed bonds

Municipal bonds

Investment-grade corporate bonds

Junk bonds

Foreign bonds

Notice on the chart to the right inside the
Wall Street Journal embedded website
regarding Treasurys that when yields rise
(green), bond prices fall (red) and when
yields fall (red), bond prices rise (green).

NOTE: The prices and yield will be
shown in black when there is no change
or the bond market is closed.

These government IOUs are called T-Bills, T-Notes, and T-Bonds. The "T" stands for "Treasury."

T-Bills mature in one year or less.
T Notes are issued in terms of 2, 3, 5, 7, and 10 years.
T-Bonds are issued in a term 30 years.

Another government bond that has slowed in sales since 2012 is the U.S. Savings Bond. To purchase a savings bond today, you
have to go to the Treasury Direct website, fill out a form that asks for your taxpayer ID number, Social Security number of the
person who is receiving the U.S. Savings Bond, and your bank account number. It is now quite cumbersome to purchase a
U.S. Savings Bond.

For the history of the U.S. Savings Bond click on this link: U.S. Savings Bond
For information on how to purchase a U.S. Savings Bond click on this link: U.S. Savings Bond Purchase

Nearly 90 percent of mortgages written today are backed by Fannie Mae and Freddie Mac, both government-sponsored
enterprises (GSEs). Freddie Mac allows for mortgages to be bundled together and sold as investments on the secondary
mortgage market.

For information on Freddie Mac click on this link: Freddie Mac FAQs

Municipal bonds are issued by states, county, and cities to raise money for government expenditures. Many municipal bonds are
usually exempt from state taxes, thus making it an attractive investment for individuals in higher tax brackets and/or in states
that have high state income taxes.

For information on How to Buy Municipal Bonds click on this link: How to Buy Municipal Bonds

Investment grade indicates the quality of the company's credit
rating. To be investment grade, a company's bond rating must
be rated Baa3 (Moody), BBB - (S & P), and BBB- (Fitch) or higher.

According to S & P a 'BBB' rating "exhibits adequate protection
parameters. However, adverse economic conditions or changing
circumstances are more likely to weaken the obligator's capacity
to meet its financial commitments on the obligation."

If the company or bond is rated 'BB' or lower it is known as junk
grade, in which case the probability that the company will repay
its issued debt is deemed to be speculative.

According to S & P any bond rated less than 'BBB' by S & P "are
regarded as having significant speculative characteristics.
'BB' indicates the least degree of speculation and 'C' the
highest. While such obligations will likely have some quality
and protective characteristics, these may be outweighed by
large uncertainties or major exposure to adverse conditions.

Foreign bonds are issued by foreign entities (foreign governments or foreign corporations) and traded in that country's
currency and in that country's financial market. You can see why these types of bonds tend to come with great risk.

https://learnbonds.com/news/bond-credit-ratings-table/

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*TheStreet.com

Steven M. Reff
Economics Lecturer
University of Arizona
(2007 - 2016)
The 2015 University of Arizona
Five-Star Faculty Award