Bonds are considered a fixed investment that can help you protect your savings. Bond investors can earn money in two main ways: collecting income from interest and realizing capital gains. It’s important to understand these concepts, along with other fundamental principles of bond investing, if you’re interested in investing in fixed-income securities.
Collecting Income from Interest
When you buy a bond, you are lending money to the issuer. Sometimes, the issuer is a company (corporate bonds), and other times the issuer may be a government or municipality (sovereign or municipal bonds).
The interest rate, or coupon rate, is determined based on the general level of interest rates at that time, the bond’s maturity date, and the credit rating of the issuer. For example, if you purchase a $1,000 bond from a company when it is issued, and the coupon rate is 7%, you should receive $70 annually as interest income.
If the maturity period is 30 years in the future, you will receive your original investment of $1,000 back after 30 years from the bond’s issuance date. This can be a great deal for you because you will get additional money, and it’s a great deal for the company as well because it can use that money to build new facilities, expand its product lines, or meet other needs.
Note: To understand the relationship between making money in bonds and interest rates, read about a concept known as bond duration.
Realizing Capital Gains
Many bonds are often not held until maturity. If you need to retrieve your money before the bonds mature, you have the option to sell them through a broker. When this happens, you may realize a capital gain or incur a capital loss depending on what has happened to the credit quality of the issuer and the direction of interest rates.
If the company that sold you the bond turns out to be in deteriorating health and is about to file for bankruptcy, you will only receive a few cents on the dollar because other bond investors will not be willing to take the risk unless they are compensated with a higher yield. Similarly, if interest rates rise, your bond will lose value because investors will demand that you offer a yield higher than the coupon rate.
For example, if you bought a bond from a company that provides a 7% yield, and suddenly similar bonds start offering a 10% yield, you will have to lower your price so that your bond’s yield is 10% as well. Investors are unlikely to buy it if they can purchase a newly issued bond with a higher yield.
On the other hand, if interest rates on bonds decline, you can sell your bond at a higher price to realize a capital gain.
More Resources for Bond Investing
Before investing in bonds, it’s important to familiarize yourself with some basic concepts. Here is a list of some resources that can help you with that:
- What is a bond?
- Investing in Bonds 101
- Investing in Corporate Bonds
- Investing in Tax-Free Municipal Bonds
- Investing in Savings Bonds
- Risks of Investing in Junk Bonds
- How Investment-Grade Bonds Can Help You Avoid Credit Losses
- Risks of Investing in Foreign Bonds
- How Bond Yield Spreads Can Cost You a Lot of Money
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Source: https://www.thebalancemoney.com/making-money-from-investing-in-bonds-357899
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