Bond Frequently Asked Questions
Learn more about bonds and bond funds by reviewing common questions that many have asked about bonds…
Q: What can I do to position myself for successful bond investing?
A: It is important that you “have all your bases covered” prior to starting on your bond investing or any investing as it is important that you have reduced or eliminated your debt to an acceptable level, you have a properly funded emergency fund (or you are working toward that goal), you understand credit—and you have looked at your finances in a comprehensive way.
By doing the above you put yourself in position for lasting success and you make your bond investing (or any investing) more likely to succeed—and even if you are unsuccessful your living conditions won’t be adversely affected.
Q: What is a bond?
A: a bond is a debt instrument used by corporations (and government entities) to help fund their growth. Bonds are issued in increments of $1,000 and are sold at either a discount (below $1,000) or at a premium (above $1,000) and yield and yield to maturity is used to determine rates of return.
Interest rate movement will play a large factor in determining the actual yield or yield to maturity. Bonds come in all durations with short, intermediate, and long-term available on the markets.
Governments also issue bonds (i.e. series EE and Series I) directly to individuals as well and they also issue municipal bonds and treasuries among others.
Q: What is a bond fund?
A: a bond fund is a collection of bonds and can be mixed in any number of ways such as corporate and government, long-term only, short, intermediate and long-term, national and international and many other ways that a bond fund manager sees fit to create.
Q: What is the difference among corporate, municipal, government, international, series EE, series I and junk bonds?
- Corporate bonds are a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company’s physical assets may be used as collateral for bonds.
- Municipal bonds (or “munis” for short) are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems etcetera. Generally, the interest on municipal bonds is exempt from federal income tax, however some municipalities issue both taxable and non-taxable munis. Pension funds and foreign investors normally don’t get the tax break.
- Government bonds are a debt security issued by a government to support government spending. Before investing in government bonds, investors need to assess several risks associated with the country, such as country risk, political risk, inflation risk and interest rate risk, although the government usually has low credit risk. Federal government bonds in the United States include savings bonds, Treasury bonds and Treasury inflation-protected securities (TIPS).
- International bonds are a debt investment that is issued in a country by a non-domestic entity. International bonds are issued in your country but are purchased outside of the country in which you reside and are purchased in your country’s currency. They pay interest at specific intervals, and pay the principal amount back to the bond’s buyer (you) at maturity in the same manner as domestic bonds.
- Series EE bonds are a “non-marketable”, interest-bearing U.S. government savings bond that is guaranteed to at least double in value over the initial term of the bond, typically 20 years. Most Series EE bonds have a total interest-paying life that extends beyond the original maturity date, up to 30 years from issuance.
- Series I bonds are a non-marketable, interest-bearing U.S. government savings bond that earns a combined: 1) fixed interest rate; and. 2) variable inflation rate (adjusted semiannually). Series I bonds are meant to give investors a return plus protection on their purchasing power. Series EE and I bonds are considered “non-marketable” savings bonds meaning they can’t be bought and sold in the marketplace. The can be redeemed at many banks and financial institutions.
- Junk bonds are a fixed-income instrument that refers to a high-yield or non-investment grade bond. Junk bonds carry a credit rating of BB or lower by Standard & Poor’s (S&P), or Ba or below by Moody’s Investors Service. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds.
They do well when the economy is growing rapidly and stocks are rising.
Q: What are bond rating agencies and how do they operate?
A: There are a number of bond rating agencies and they include Weiss, S & P’s, Moody’s, Fitch and several others and they rate corporations, cities, counties, states and national government’s based on their ability or perceived ability to repay their debt.
In a sense it is based on the financial strength that they bring forward based on their past, present and projected ability to repay their debt obligations.
Q: What is the bond rating of the United States?
A: With the United States being the strongest economy in the world in the minds of many it is a big surprise for many when they learn that the United States does not have the highest bond rating.
The United States was recently downgraded from AAA to AA by Moody’s and Standard & Poors (several credit rating agencies around the world have downgraded their credit ratings of the U.S. federal government, including Standard & Poor’s (S&P) which reduced the country’s rating from AAA (outstanding) to AA+ (excellent) on August 5, 2011.
Q: If the interest rate rises what will happen to bond prices?
A: The bond price “will fall” as there is an inverse relationship (opposite relationship) to bond prices–meaning if interest rates fall bond prices will rise.
Q: What is YTM or Yield to Maturity and how do I determine what my YTM is prior to purchasing a bond?
A: Yield to Maturity takes into consideration the interest (coupon payments) during the period of bond ownership up until the bond is sold at its maturity date—thus YTM.
Yield on the other hand only includes the coupon payments that you will receive on an annual basis.
You can possibly get the YTM or projected YTM from your broker or other published financial publications.
Q: What is duration as it relates to bonds?
A: Duration is a measure of a bonds interest rate sensitivity. You can use a bonds duration to make a better decision as to whether the bond will rise or fall based on interest rate movement.
Q: How are bonds taxed?
A: Many are taxed depending on whether they are inside or outside of a retirement account and the taxation is based on the interest received during the year.
If they are inside of your retirement account they may avoid taxation until withdrawals or retirement distributions begin to occur. Some bonds (depends on the type) are taxed on an annual basis and some are taxed at maturity and those that are used for certain purposes may avoid taxation altogether.
Q: What is the biggest risk that I will normally face if I invest in bonds?
A: Market activity is the real key especially as it relates to rising inflation. If inflation is stable or not moving upward much, interest rate movement will normally be stable as well and bond investments will remain a good play.
When a large number of bondholders move over to stocks for varying reasons that too can be a cause for concern.
However, rising inflation is something you must be aware of and if you are a bond owner you want to be aware of that movement so that you can countermove and limit your losses or protect your gains—in a timelier manner.
Q: What is bond laddering and how can I ladder my portfolio to increase my returns?
A: You can ladder your portfolio by purchasing bonds at different times and purchasing bonds with differing durations.
For example you can purchase short, intermediate and long-term bonds at differing intervals such as every 6 months, every year or every other year for a specified period of time—and that will help protect your gains or limit your losses.
Q: What is my number 1 concern if I decide to invest in bonds?
A: Depending on the type of bond you invest in inflation is normally the major concern as it will devalue the real worth of future interest payments and usually results in higher interest rates that will bring down the bond’s current market value.
Q: What is an inverted yield curve and how will it affect my bond investments?
A: It usually means the economy is slowing and moving into a recession. Investors may forecast lower interest rates and pull money out of bonds and put into cash, stocks or mutual funds.
Q: How are bonds typically sold?
A: Usually in multiples of $1,000 if you purchase from a broker. Bond funds and mutual funds may offer investment of a lower amount. Series EE and I bonds can be purchased for as little as $50.
Q: If a company liquidates where do I as a bondholder fall in claiming whatever cash becomes available as a result of the liquidation (bankruptcy)?
A: The good news is that bondholders are first in line to be paid during bankruptcy proceedings. You would be considered a general creditor, along with employees, contractors and suppliers–stockholders would be the last in line.
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