Trading Lessons

What is a Bond and are they a good investment?

US Treasury Bonds
Written by Noah Hochman

US Treasury BondsThe easiest answer to this topic is that Bonds are a form of debt. You are loaning money and expect that money to be returned with a little extra for your trouble. When you are purchasing a stock you are taking an equity stake in a company, that is, you become an owner in that company., how large an owner depends on how many shares of stock you have purchased. When you purchase a Bond you will have a creditor stake in the company, you have loaned money to the company for them to finance some project or another. Companies, cities and even governments issue bonds for sale with the promise they will pay you back in full with interest. A company may sell bonds to build a new facility, a city to build a bridge and the government to finance its daily operations. Bonds normally have a specific term or what is called maturity date. This is the legnth of time when the bond can be redeemed. This also differes from a sharae of stock which can be owned indefinately if the purchaser so chooses or sold right after its purchase.

When you purchase a bond you know that after a certain period of time you are going to get your money back and during that time you will also know at what point or what intervals you will collect your interest for loaning that money (buying the bond). If you need to sell your bond before the “maturity date” the price you will get for it will depend upon the current interest rates. If the company (or city, etc.) that issued the bond goes bankrupt, well, you probably won’t get back all your money, but you do have priority over stock holders as if you remember they are “owners” of the company and “lenders” have priority in getting paid back after selling off the company’s assets.

So what establishes the price of a bond and the interest rate? Well, it comes down to risk. The length of time till maturity, this is the amount of time you are loaning the money for, which is just the maturity date. The longer the time to maturity the greater the risk that something could go wrong such as financial difficulties, a natural disaster will force bonds to drop in value. They drop in value because less people will want to buy them at the original price when the can purchase bonds in more secure companies for relatively the same cost.

Interest rates also play a huge role in the price of bonds as anyone who has been watching the business news on television lately. The interest rates on bonds is fixed when they are sold, so as economic conditions change the interest rates change, if interest rates go higher the value of bonds will go down and if interest rates go down the value of bonds will increase. Remember that the interest rate of the bond you already purchased doesn’t change. So, if interest rates have gone up from the point that they were sometime in the past year or so, an individual just looking to buy bonds could get a higher interest rate than the person who bought a bond last year. If you are holding the bonds you bought last year at the lower interest rate, the only way some other investor would buy them is if you sold them cheaper than what you paid for them last year.

In a nutshell, risk is the determining factor in interest rates and bond value. Risk can be looked at as the length of time to maturity or the credit worthiness of a company or city, etc., the more risk you take the more you deserve as a return on your investment. United States Treasury Bonds have always been considered the safest bond investment due to the fact that the chance of the US government actually defaulting on them is very slim. A riskier bond would need to provide a higher return to make up for the higher risk incurred by the bond purchaser.

The bottom line for the new investor to understand is that risk comes in various forms, the amount of time until maturity, the credit worthiness of the issuer, General Electric should be less of a risk than Joe’s 5 day old fish market and finally what are the interest rates being offered.

Noah Hochman

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Noah Hochman

1 Comment

  • This explanation of bonds gives me a better understanding. But I would also like to know something about Nominal Risk and the factors influencing it

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