Steven asks…
My bank talked me into investing in bonds. The market value of my bonds have been dropping. Should I worry?
Will I get like they claim both my principal and interest at maturity or should I ask for my money now and avoid more losses later?
financi4 answers:
The market value of a bond will fluctuate depending on the changes in interest rates. If you hold the bond until maturity, you will still get your principal back, as was stated in the bond’s contract.
Here are some exerpts from my book:
“Before I go much further, I want to make sure you understand what total returns are. I am not just talking about the interest, or coupon, payments from bonds. That is one source of returns. There are actually two more. Secondly, interest can be reinvested to purchase more bonds which pay more interest. This is called compounding, or interest-on-interest. And thirdly, you can incur a capital gain or loss if you purchased your bond for a price other than par. For example, a discount bond sold for $900 will be redeemed for $1000 (its par price) on the maturity date, and thus the investor will receive a $100 capital gain as part of the bond’s return. When we look at historical data, we are looking at total returns which include all 3 sources of income. ” – Page 87
“The first risk we will discuss is interest rate risk. It is the prominent risk inherent to bonds. It exists because bonds traded on the secondary market must compete with newly issued bonds.
As long as the bond’s issuer remains stable, the bond gives the investor a guarantee that the issuer will make the interest (or coupon) payments at certain intervals and will then pay back the original sum of money lent (the principle) at a specified date (the maturity date). It is because of this that most investors assume high-quality bonds have no risk.
The problem occurs if you wish to sell your bond before it matures, on the secondary market. If interest rates have risen since you bought your bond, newly issued bonds will be sold with higher coupon payments than what your bond pays. As a result, no other investor will buy your bond at the par price. Why would they? They can, instead, purchase a newly issued bond at par price, but one that pays higher interest. So, in order to make your bond competitive, you would have to sell it at a discount. The discount necessary would be the price at which your old bond yields the same interest to the new investor as the newly issued bonds would. Remember that bonds are only issued and redeemed at par. What happens in between is based on free market forces.
Let me illustrate with an example. Let’s say that you bought a 10-year Treasury bond on the day of its issue, at $1000 par. It was issued with a 5% coupon rate, meaning that it pays $50 per year in interest. A year later, you want to buy an Xbox 360. So you decide to sell your bond on the secondary market to get your money back. But the Fed has raised interest rates. Now, 10-year Treasury bonds are being issued with a 7% coupon rate. These new bonds are sold at $1000 par and pay $70 per year in interest. You cannot simply sell your bond at its par price of $1000 because no rational person would buy it from you at that price. They would buy the new bonds instead. In order to sell your bond, you would have to lower its price to around $714. Your bond still pays $50 per year in interest, as is stipulated in the bond’s contract. But now, the new owner buys it for $714 and receives $50 per year in interest, which calculates to a 7% interest rate (50 divided by 714 = 0.07), the same as newly-issued Treasuries. (In actuality, the change in price is more complicated that this. I oversimplified to help you understand the basics.)
The actual coupon payment has not changed. Rather, the ratio of that coupon payment to the price has changed. In a secondary market where people can choose to sell their bonds before maturity, prices of outstanding bonds will fluctuate based on prevailing interest rates. This is because current interest rates influence newly-issued bond coupon rates, which compete with outstanding bonds. The outstanding bonds still pay the same coupons and are redeemed at the same par amount on the maturity date, but their selling prices will fluctuate while outstanding.” – page 88
“All bonds fluctuate in response to interest rate changes. Even ones with insurance backings and inflation protection. No exceptions. The difference is that long-term bonds (ones with long maturities) fluctuate more widely than short-term bonds in response to interest rate changes. Long bonds tend to have higher coupon payments than short bonds, so there is more to lose if interest rates rise. On the flip side, if interest rates fall, the long bonds have “locked in” their higher coupon payments longer than short bonds, and thus increase in value more than short bonds.”
“Now, if I buy my bond at issue and hold it until maturity, I will never have to deal with selling it at a lower or higher price. However, if interest rates increase such that future bonds offer better coupons, I incur an opportunity cost. I am potentially losing money since I could be receiving higher coupon payments with the newer bonds. So do not think that even if you hold your bond till maturity that its value never changes. The coupon and par amount remains the same, but the bond’s value fluctuates. In the early 1980s, Treasury bonds were being issued with obscene coupon rates of 15%. The investor who held his old 8% bonds certainly incurred an opportunity cost. Which bond would you rather have in your portfolio?”
A free copy of my book is available for download from my website, in PDF format. Click on my profile and read my info to get the site.
Thomas asks…
I want to start investing in stocks/bonds/mutual funds but what are the first few steps?please help?
financi4 answers:
First you should learn how it works by reading a lot.
You can start with books like investing for dummies. Read the financial press.
Then decide what kind of investor are you. A day trader buying and selling everyday or a fundmental investor, researching investments and investing for medium/long term.
You can start investing with a virtual account or with a real account but with a small amount (an amount you are ready to loose).
Daniel asks…
Investing in California bonds good idea?
heard adds on the radio, that they are tax free.
financi4 answers:
If you live in California, the bonds are double tax free – both at the Federal & the State level.
But, if you get hit by the AMT, this will change. Check your tax situation.
I do not think California bonds are a good investment at this time. The state is in a huge fiscal mess, and it’s deficit is the largest in the entire USA. Add to that the goons currently in the government and it is a sludge heap that cannot be trusted whatsoever. The likelihood of California defaulting on its bonds is getting higher and higher, and if they do, your investment could be cut into pennies on the dollar.
Do not do it. There are much safer investment alternatives.
Mark asks…
Stocks/Bonds & Investing question?
Hello, I am 19 and am very interested in investing. I really know nothing about investing at all, and would like some advice to help develop some ground work as to how I will go about doing things. I am looking to to long term invest. Any questions let me know, and return after to check the additional details.
how would I invest in an idex fund, and is there any other advice you can give? This is all foreign to me.
financi4 answers:
Since you have completely no experience I suggest that you do not go anywhere near a broker until you learn the basics.
Online trading in the stock market offers unlimited potential profits….but….The first thing you need to know is that most beginners lose money. Most people rush in to trading looking for easy money without really knowing what they are doing.
Try virtual trading before you risk real cash.
Virtual trading will let you see if you can make money and will give you the knowledge and experience that you need to become successful without risking your savings first.
You will learn a lot and you will still have your start up fund in the bank until you know you can make money from trading.
Chris asks…
Stocks, bonds investing?
Is there such thing as a company which invests your money in stocks, bonds etc and then takes a small cut of profits?
They have the knowledge of how the market drops and rises etc, and the customers simply hand the money to them to invest (Not risk free of course)
financi4 answers:
That would be a private fund, known colloquially as a hedge fund. Typically they charge a 1% management fee and a 20% share of the profits over a 6% hurdle. They don’t advertise and they either keep the number of investors to 100 or less or they restrict their investors to “qualified purchasers” such as people with over $5 million in investment assets. If they don’t keep to these restrictions then they will have to register as a mutual fund in which case they would have more reporting requirements and not be allowed to share in the profit hence they would have to depend on the fee for income.
Michael asks…
Is investing in tax free bonds good in this day and age?
I am considering my state’s tax free bonds sold through companies like Vanguard. That way, my investment will be tax exempt from those thieves at the federal and state governments. However, those are just IOUs from city or local governments from my state. The way government is going these days, not sure they are stable, but I would think they can be good as long as the amount of investment is below my tolerance level?
Please share your opinions and experiences. Thank U!
financi4 answers:
There has not been a state bond that has failed. Very, very few municipal bonds have ever failed. No school district GO bond has failed. Many munis carry high rating and bond insurance. GO–general obligation bonds are considered safer, because they have the taxing authority behind them. However, revenue bonds for things that people always use e.g. Water, airports, etc. Have been quite safe. So safety is usually not the issue. Generally they pay a lower rate, so you should consider your tax bracket, does the tax savings make up for the lower interest rate. Generally in the 25% bracket it will. Also, understand that the market value of a bond can fluctuate as interest rates move around. That is not a problem if you are just going hold them and collect the interest payments. Longer bonds will move around more in price but pay higher interest rates.
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