The bond market is the place you purchase debt. If you're buying government bonds, you're loaning the federal government money. If you purchase municipal bonds, it's a state or local government that benefits from your loan. Corporate bonds are just as they say, a loan to a corporation.
Bond owners get paid on these bonds two ways. The bond pays interest, which is the coupon rate and the bond holder collects at specific intervals, normally annually or semi-annually. So if you purchased a $10,000 bond with a coupon rate of 3 percent, you'd receive $300 every year from the issuing corporation.
The bond market holder also receives the full face value of the bond at the maturity date. That brings us to the second way to make money in the bond market. You can buy bonds at a discount, meaning for less than the face value. Scenarios like that occur if the bond issuer's credit rating is shaky, which would mean the bond's rating would be below BBB, with the highest rating at AAA. Normally, these types of bonds are discounted, meaning a $10,000 bond might cost $5,000.
The further away from maturity, when the borrower has to pay the bond owner, the more the discount. That's because of the uncertainty of holding a bond that length of time. The company could go bankrupt or interest rates could rise dramatically and your money would still be tied up in the bond. If you purchased the bond at a discount, the price could rise and you'd make money by selling it or the bond could mature and you'd make money. However, prices can drop and companies or government entities can have severe financial problems and that's when you lose money buying bonds.
Some people purchase bonds for income and normally these people buy high-quality ones, but for those who have the money to risk, buying discounted bonds for income can increase the amount they get dramatically. If you purchased a $10,000 bond at a discount, for $5,000, for instance, and the interest rate was 3 percent, you'd make the 3 percent on the face value of $10,000, which effectively doubles the amount of interest you receive.
When interest is low and stocks are rising, the bond prices drop. After all, if you can make 12 percent on stocks for the year, why would you settle for 3 percent on bonds? However, when the interest rate goes up, bonds start to look more attractive. For those who want a safe investment, high quality corporate or government bonds can be a major part of their portfolio. If someone is in a high tax bracket, investing in municipal bonds can give them income that's tax-free, making the actual spendable after tax return higher, since there's no taxation to lower it.
If you really like excitement in your life, consider taking a small amount of money and investing in the junk bond market. Not all brokerages allow purchases of junk bonds as a protection for their clientele. Investing in these types of bonds is a risk, but if the spread between the interest paid and the interest on high-grade bonds is large, or you can get an acceptable bond at a huge discount, the rewards are huge. One way more conservative investors and investors with limited money to “gamble” in this market can reap some of the rewards of the junk bond market with less risk is to invest in a junk bond or high yield bond fund.
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