Depending on which side of the formula you’re on, bonds can be either a loan you make or a financial obligation you settle. Bonds essentially are loans that investors make to corporations and governments. They are also understood to be fixed-income investments due to the fact that the company or government that borrows the money and issues the bond normally pays the bond investor (the lender) a fixed amount of interest over a pre-defined duration of time.
At the end of the term, the company or government pays back the initial investment (the principal) to the investor. All bonds have a stated value (the rate of the bond), and a coupon, which is the yearly rate of the interest the bond pays. For instance, an investor who purchases a bond with a face value of $1,000 and a coupon of 4 percent will pay $1,000 for the bond and receive $40 in interest repayments each year for the length of the term.
Due to the fact that investors get back (usually) their original investment, there is a reduced amount of threat involved in bond investing. Consequently, the amount of interest represented by the coupon rate is typically lower than the historical returns generated by equity (stock) investing.
Bond investors will constantly get the prevailing rate that’s required by the market. Bonds with high coupon rates have higher prices, negating that greater rate and bonds with low discount coupon rates have lower prices, making that lower rate seem more attractive. So when bond rates go up, the prices usually come down and when bond rates dive, the price goes up, creating an inverse relationship.
Why investors buy bonds
Investors buy bonds in order to develop profiles that fit their optimal asset allowance according to their personal risk tolerance. Bonds often have a reduced correlation with stocks – that is, when stocks fall, bonds often rise. So possessing bonds can help provide a hedge or a “safety cushion” in the event of a decline in the securities market. In addition, bonds offer a stable stream of earnings at rates considerably higher than the historical average dividend yield of stocks– about 5 percent each year for bonds compared to just 1.5 percent approximately for stocks … but your mileage may vary as dividend stocks bounce in and out of favor with investors.
Why bond prices change
Think of it like this: if the prevailing interest rate is 3 percent however a bond has a rate of 12 percent, would not more investors desire that bond? Exactly what takes place when more individuals want something that is rare? You got it – that item jumps in price – and bonds are no different.
On the other side, should the prevailing rate be 8 percent buy a specific bond has a coupon rate of only 4 percent, that bond will be priced at a discount to lure investors to purchase it. After all, why purchase a 4 percent financial investment when you could purchase an 8 percent investment? Because you can purchase it at a price cut to make up the interest you would not get.
How bond ETFs work
Bond exchange traded funds (ETFs) track indexes comprised of specific bonds. Bond ETFs don’t have a face value or a discount coupon rate due to the fact that those elements are tied up into the bond’s share price. The bond ETF’s share price is determined by the costs (face values) of the specific bonds in the index that the ETF tracks. Subsequently, when the prices of those bonds in the ETF increase, the ETF’s share price also rises. When the bond prices fall, the share price falls. Instead of a discount coupon rate, bond ETFs have a yield or interest payment that equates to the typical price of the bonds in the index tracked by the ETF. While the interest repayment on a specific bond is fixed, the yield of a bond ETF can change as the individual bonds in the index tracked by the ETF change. But, these interest rates change only in small quantities.
Why investors buy bond ETFs
Investors purchase bond ETFs for the same reason they buy bond shared funds – to prevent the hassle and cost of purchasing a collection of individual bonds. Bond ETFs often tend to have lower expense ratios than a lot of bond mutual funds but, the choice of bond ETFs is rather limited though there are hundreds of bond shared funds. Still, there are a variety of options for bond ETF investors who desire exposure to the total bond market conveniently and at a low cost.
Where to buy bonds or bond ETFs
Any online broker can help you purchase bonds, bond ETFs, or bond stock funds. Below are a few to think about.
- Scottrade – you can buy certain ETFs commission free!
- optionsXpress – one of the easiest online brokerages to set up. No paper forms or signatures required.
- TradeKing – offers regular trades and broker assisted trades for only $4.95.
- optionshouse – this is basically the least expensive online brokerage for investors.