Are Us Savings Bonds Right For You?
Posted on June 22, 2008
Filed Under Personal Finances |
Bad Ian Fleming reference aside, the main function of a bond is that you are lending money to a organization for an agreed time frame, and receiving an agreed rate of return. This is called the coupon rate and is based on the original capital invested. The trick is figuring out how much of your investment portfolio should be in stocks versus bonds.
If you’re interested in investing in bonds, which type should you choose? Investing in bonds can take many forms, but the key to understanding the bond markets is that when you buy a bond, you are lending someone money, be it a government or an organization.
The principle advantage of bond investing is that they’re rated by their risks. The bond has a term where it pays off (ie 10 years) at which point you get your initial investment back. Bonds will pay a set amount of income of whatever their return rate is, taken as a percentage of the initial investment. Therefore, if you invest $100,000 in a series of bonds that return interest at a coupon rate of 3.5%, each year, you’ll receive $3,500 of interest income. The main advantage of bonds is their steady income stream. Add to that you get the initial investment back when you’re done.
So, what’s a intelligent investment strategy when it comes to bonds? It depends on the type of bond you are purchasing. Short term (less than 5 years) bonds usually have low coupon rates, but have the advantage that your money is nottied up for enjoying retirement, you’re most likely to have a bond maturing to give you an immediate lump sum of cash. Medium term bonds tie your money up for longer stretches of time (typically more five to seven or ten years.), while long term bonds tie your money up for 10 to 30 years or more. The coupon rate will also vary with the credit worthiness of the company the money is lent to; lower credit ratings result in higher coupon rates, and the highest credit rating is typically governmental bonds; this is one reason why the 30 year Treasury bill (or T Bill) is used as a baseline bond metric.
There’s more to investing money in bonds than the coupon rate. Since bonds can be bought or sold at any time, very few people hold bonds to their full maturity, and bond funds keep portfolios of bonds with different maturity rates. In general, when the interest rate goes up, the price of an existing bond goes down, because buying a new bond at the higher rate gives a higher rate of return. When the interest rates go down, the bond price of an existing bond goes up, because it gives a higher rate of return than a newly purchased bond would.
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