When simplified, the investment markets can be broken down into two types: equity and debt. Equity investments are purchases of stock in a company and represent a part ownership of the business. Stockholders may or may not receive annual dividends. Debt investments, on the other hand, represent a loan to the company with the corresponding return plus interest expected. A bond holder is entitled to regularly scheduled interest payments. Debt investments are considered a little more secure than stocks, but there is risk associated with any investment.
Debt investments are commonly known as bonds. Bonds can be issued by federal, state and local governments as well as by corporations. There are advantages and disadvantages with either. For example, if you invest in a federal bond issue, the interest income you receive on this investment is generally not taxable on the state and local levels. Similarly, state and local bond issue interest income is generally not taxed on the federal level. Corporate bond interest income is taxed everywhere.
It’s a good idea to get an interest rate education before investing in debt instruments. In the United States, the Federal Reserve Bank (or, the “Fed”) sets interest rates. They do this at a meeting held every six to eight weeks in which the national economy is evaluated. They then decide what to do with interest rates. This decision is based on many factors, but primarily the rate of inflation being experienced.
If inflation is on the rise, the Fed may raise interest rates. This makes the supply of money (in the form of loans) a little tighter and harder to come by, which, in turn, slows the inflation. If there is no or very little inflation, interest rates will probably remain as they are. If there is deflation, or a slowing economy, the Fed may attempt to stimulate it by lowering interest rates, allowing more people to borrow, hence stimulating the economy.
The reason you need to know about what’s happening to interest rates before you invest in bond issues is because the prices of bonds are directly related to the current available interest rates. In general, if the interest rates are rising, the price of the bonds is falling and vice versa. Of course this means next to nothing if you intend to hold the bond to maturity. This is notable only if you, like most bond investors, tend to hold it a shorter time, selling it before maturity. So if you sell a bond before maturity during a period of rising interest rates, the value of the bond may be less than it was when you purchased it.
The main features of a bond issue that you need to know are:
Coupon Rate – This is the interest rate that will be paid to you on this loan. You should also know when it is paid. Usually this is once or twice per year on specified dates.
Maturity Date – This is the date the loan becomes due and payable. On this date the company will pay back the principal you loaned to them.
Call Provisions – Some bonds come with a right of the borrower to pay back the loan proceeds early. Some are non-callable. Those that are callable are usually paid back at a higher price than you paid originally when the early option is exercised. Note that when a bond issue is callable and interest rates are falling, the company will often find it financially advisable to buy back your bond with the proceeds from a new bond issue at the new lower rates.
The biggest risk in bond investment is that the issuer will go out of business. This is why federal bonds are so popular; there is virtually no chance of the federal government going out of business! Federal treasury bonds are amongst the most secure investments you can make. Corporate bonds, however, are a different story. Any company can go out of business for any number of reasons. If you have an investment in a company’s bonds when this happens, your investment is almost worthless almost immediately. Bondholders DO have priority over stockholders, though, and will get paid first. Senior bondholders can even lay claim to physical assets upon liquidation of the company.
Bonds are a good fairly safe investment as long as you take these risk factors into effect. A good mix if corporate, federal and local government bonds is advisable. Even throwing some junk bonds with high interest rates could be profitable. Diversification lowers risk, even in the bond market.