Bond Tips

Bonds are often considered safe investments. So safe in fact that, many people invest in bonds without understanding how they work. You can maximize your approach to bond investing if you take notice of the following five tips.

1. Understand key terms. Do you know what a bond's par value, coupon rate and maturity date really mean? You must familiarize yourself with the basics before you can fully understand their impact on your investment. When bonds mature, you receive what's known as the bond's par value. The coupon rate is the amount of interest you'll receive, generally expressed as a percentage of par value. The maturity date, as the term implies, is when you'll receive the principal that you invested.

2. Calculate the yield. You must calculate the bond's yield in order to compare it with other potential investments. It's a simple formula. Yield equals the amount of interest the bond will pay in one year divided by its current price.

3. Review the bond's rating. Bond ratings indicate the financial stability of the bond issuer. For example, bonds carry default risk. This means that there is a possibility the bond issuer will not be able to pay interest or principal when the bond comes due. You should always check the bond's rating before you invest in it. Standard & Poor's and Moody's are third party services that rate bonds. Typically, the higher the rating, the higher the quality of the bond.

4. Be aware of interest rate risk. Interest rates and bond prices move in opposite directions. For example, as interest rates rise, bond prices fall. Interest rate risk is a term used to describe the risk that a bond's price will change as interest rates fluctuate. Longer-term bonds are more susceptible to interest rate risk, because they have a long future of interest payments that may or may not correlate with current rates. As a result, the bond price continually adjusts in order to compensate for changes in interest rates.

5. Think before you sell. If you hold the bond until it matures then its price will not change. However, you can make or lose money on bonds if you buy and sell before they mature. The amount you earn or lose depends on the bond's maturity date, transaction costs and interest rates. If you want to sell before it matures, you should examine the bond market to determine how easy or how difficult it is to sell the bond.

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