When simplified, investment markets can be divided into two types: equity and debt. Equity investments are purchases of shares in a company and represent partial ownership of the company. Shareholders may or may not receive an annual dividend. On the other hand, debt investments represent a loan to the company with the corresponding return plus the expected interest. The bondholder is entitled to regularly scheduled interest payments. Debt investments are slightly safer than stocks, but there are risks associated with any investment.
Debt investments are generally known as bonds. Bonds can be issued by federal, state, and local governments as well as by corporations. There are advantages and disadvantages with either of them. For example, if you invest in a federal bond issue, the interest income you receive on that investment is generally not taxed at the state and local level. Similarly, interest income from state and local bond issues is generally not taxed at the federal level. Corporate bond interest income is taxed everywhere.
It is a good idea to get an interest rate education before investing in debt instruments. In the United States, the Federal Reserve Bank (or “Fed”) sets interest rates. They do this at a meeting every six to eight weeks at which the national economy is assessed. Then they decide what to do with interest rates. This decision depends on many factors, but primarily the rate of inflation that occurs.
If inflation is rising, the Federal Reserve may raise interest rates. This makes the money supply (in the form of loans) tighter and more difficult to obtain, which in turn slows down inflation. If there is no inflation or there is very little inflation, interest rates are likely to stay the same. If there is a contraction or slowdown in the economy, the Federal Reserve may try to stimulate it by lowering interest rates, allowing more people to borrow, thus stimulating the economy.
The reason you need to know what is happening to interest rates before you invest in bond issues is that bond prices are directly related to the interest rates currently available. In general, if interest rates go up, the price of bonds goes down and vice versa. Of course this means nothing if you intend to hold the bond until maturity. This is only noticeable if, like most bond investors, you tend to hold them for a shorter period, and sell them before maturity. So if you sell a bond before it matures during a period of rising interest rates, the value of the bond may be less than it was when you bought it.
The main features of bond issuance that you need to know are:
Coupon rate – is the interest rate that will be paid to you on this loan. You should also know when it is paid. This is usually once or twice a year on fixed dates.
Due Date – This is the date on which the loan becomes due and payable. On this date, the company will return the principal amount you lent them.
Call Terms – Some bonds come with the right of the borrower to repay the loan proceeds early. Some are not callable. Callable ones are usually paid back at a higher price than you originally paid when you exercised the early option. Note that when a bond issue is callable and interest rates lower, the company will often find it financially desirable to buy back your bonds with the proceeds from the new bond issue at new lower rates.
The biggest risk in bond investing is that the issuer will go out of business. This is why federal bonds are so popular. There is almost no chance of putting the federal government out of business! Federal Treasury bonds are among the safest investments you can make. But corporate bonds are a different story. A company can go out of business for any number of reasons. If you have an investment in a company’s bond when this happens, your investment is worthless almost immediately. However, bondholders have priority over shareholders, and will get paid first. Senior bondholders can even claim physical assets when a company is liquidated.
Bonds are a good and fairly safe investment as long as you take these risk factors into play. A good mix if corporate bonds, federal and local government bonds are recommended. Even tossing some junk high-interest bonds can be profitable. Diversification reduces risk, even in the bond market.