Today, I want to discuss something that market analysts don’t talk about too often.
Before your eyes glaze over, this is important.
Bonds belong in everyone’s portfolio. Now, I’m not talking about bond mutual funds or exchange-traded funds. I’ll tell you why you should avoid those next week.
Today, I want to talk about what you need to know about individual bonds.
First of all, what exactly is a bond?
It’s pretty simple. A bond is a loan that you make to a company or government agency. If we’re talking corporate bonds, then you’re loaning money to a company for a specific amount of time for a specific interest rate.
Bonds are typically sold in $1,000 increments. Bonds have a maturity date and a coupon. For example, if a bond is set to mature on February 1, 2025, and it has a 5% coupon, that means if you lend $1,000 to a company until February 1, 2025, you will receive 5% per year in interest – usually in two payments throughout the year. On February 1, 2025, you’ll get the $1,000 back.
Now, here’s the important part. If you buy or sell a bond in the market, it may not trade for $1,000.
When it is first issued by the company, it will. But as soon as it starts trading, the price will vary.
So you could buy a bond for $900. In that case, you’ll receive more than 5% per year because the 5% coupon is based on the $1,000 figure. No matter where the bond is trading, the bond pays $50 per year in interest. So if you paid $900 for the bond, you’ll make 5.6% interest because $50 divided by $900 equals 5.6%.
If you paid $1,050 for the bond, you’ll make 4.8% because $50 divided by $1,050 equals 4.8%.
Here’s another important feature: At maturity, the bond pays $1,000, regardless of whether you paid $900 or $1,050.
It’s obvious why you might buy a bond for $900 when you know you’ll get $1,000 at maturity plus interest, but you may be asking why someone would pay more than $1,000 for a bond if they know they’ll lose money at maturity.
That’s because even with the loss, they may still make more than they would in other places.
For example, if a bond is trading at $1,050 with a 5% coupon until 2026, that means even though the investor will lose $50 at maturity, they will collect $50 in interest per year over the next five years.
When you subtract how much the bond loses at maturity from the total amount of interest paid, that comes out to $200, or an average of $40 per year. That comes out to 4% per year. In this low interest rate environment, an investor may be very happy earning 4% per year for the next five years.
One last thing about bonds – and this is really important – is how they differ from stocks.
If you hold a stock for five years, anything can happen. It could go up 10 times, it could get cut in half, it could go to zero or it could go anywhere in between.
While a bond’s price will fluctuate, on the maturity date, the bond will be worth $1,000. The only way it won’t is if the company goes bankrupt.
So you could own a stock that has putrid earnings and falls 40%. As long as the company is keeping the lights on, regardless of those putrid earnings, the bond will be worth $1,000 at maturity. The only way you lose is if the company goes under.
That’s a major reason people buy bonds. They earn some income while holding bonds, but bonds stabilize their portfolio. If you buy bonds properly, you can be extremely confident you’re going to get your money back and make money.
In fact, I have never lost money on a bond – both on bonds I’ve invested in personally and on bonds I’ve recommended to subscribers of Oxford Bond Advantage.
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