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Bond Basics: 3 Things You Must Know about Bond Investments

written by: Ashwin Satyanarayana•edited by: Jason C. Chavis•updated: 6/23/2010

Myths exist everywhere because somehow, humans have developed a unique habit of trusting the inappropriate information first. Myths seem to sprint faster than the truth. Bond investments come with its own share of juicy misunderstandings. Here is what you must know before you think of Investing.

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    Knowing all about bonds and investing in them is one thing. Knowing what exactly to do it is something else. Learning about how to make careful bond investments is important to success with them.

    Don't let the term “Fixed-income" charm you: Investors tend to follow a myth which somehow convinces them that they can't lose any money when they invest in bonds. Please don't let the name “fixed-Income" fool you. The premise on which this statement is being made is fairly simple: although the interest at which you would get back your money is “fixed", the returns you will accrue as a bond investor are not. The returns on bonds are indirectly proportional to the Interest rates – that means as the Interest rates rise, the bond prices will fall and vice-versa. The Interest rate fluctuations and its effect on bond returns is discussed in an article titled “Corporate Bond Rates: Understanding Flucuations".

    Look at the total Return of the Bond: For bond investors, one of the best things to look out for is the 'Total Return" of the Bond, which clearly represents the combination of the bond's yield and then any accompanying capital gains and losses.

    This can be explained with an example for clarity. Let's say you purchased a corporate bond issued by Widgets Inc for $1000 for a 30-year bond with a coupon rate of 8% ( which means that this bond will you $80 each year – 1000 times 8%). However, thanks to inflation after a year of your purchase, the interest rates rise and Widgets Inc. realizes that it needs more money so it decides to issue new bonds.

    The new bonds issued by Widgets inc, now issue $1000 bonds for 9%, which pay an investor $90 on a $1000 investment, which means that your earlier investment in that bond you purchased which gave you 80 USD each year isn't lucrative. You will now decide to dump it and pick up this new bond issue. However, no one is willing to buy your old bond, unless you sell it for much less than the face-value (sell it for a discount for much less than $1000).

    On a much more pleasant note, if the Interest rates fell in one year after your purchase of the bond, your bond then is effectively paying 9% while the newly issued bonds pay out only 8%, which makes your bond lucrative on the market. If you would like to disinvest now, you could sell it in the secondary market at a premium – the profit would be taxed as capital gains tax.

    Bond Investments are not the end: Never assume that your hard-earned wealth will be safe with all of it pumped into bonds. A well-devised and well-planned portfolio with a healthy mox of equity and debt (bonds) will ensure that your wealth beats the inflation, sustains the tax cuts and provides well for you when you need it the most.






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