Bonds 101 – Part 1

by Dual Income No Kids on July 13, 2007 · 0 comments

A couple of days back, we mentioned we were considering breaking out of our usual investment patterns to stay motivated. Following this idea, today I’m writing about bonds – no, not the athlete – we’re talking about the asset class.

What are bonds? Bonds are fancy IOUs. When you buy a bond, you are lending your money in return for a fixed rate of interest and the return of your capital when the bond matures.

Bonds come in a variety of diverse forms. They vary depending on the type of organization that needs to borrow money, e.g. whether a government, a corporation or some other type of entity. Also, the type of bond you can buy depends on the price of the bond, the creditworthiness of the issuer, the date when the bond matures and the structures of the interest and principal repayments. This all sounds very complicated, but most of the concepts are actually pretty straightforward.

One concept regarding bonds that you should definitely know is the role of interest rates. Interest rates have a BIG impact on the value of bonds. For example, lets assume you bought some bonds with a coupon of 6% (e.g. they pay 6% interest). Lets say that interest rates increase to 8%, your 6% bonds then decline in value relative to new bonds that pay 8%. – Think about it, would you rather have a bond that pays 6 or 8%? – The answer is obvious. The 8% bond is more valuable and people won’t want to pay top dollar for your 6% bond, thus causing the price of the 6% bond to decline. In short, you can’t ignore interest rates.

You’ll probably want further details, so you might consider popping over to yahoo finance. There have a number of highly relevant articles on this topic. Also stay tuned here at DINKs. We’ll be covering more of the basic issues of bonds, including how not to get ripped off when you buy them.

Best,

James

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