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Financial Literacy

Financial Literacy

Home Finance Investing The Pieces of a Bond

The Pieces of a Bond

On the surface, it can look pretty simple. You buy a bond and—boom—you have a security.

Right?

Well, like most things created by money people, there's a lot going on behind the scenes. Your bond is likely made up of a bunch of stuff. Here's the lowdown:

Principal

The principal is the amount you've paid to the government or a company to help them out with debt; it's the amount you're going to be earning interest on.

Oh, and it works with loans, too. If you take out a mortgage, the principal is the amount the bank hands you and that you'll have to pay back with interest.

Interest Rate

Here's where the good stuff starts. The interest rate is the percent you'll get as a big ol' thank-you for lending the money. The higher the interest rate and the higher the principal, the more moolah you'll make from your investment.

Compounding

Compounding is the process by which your interest is tallied up. If you buy $1,000 in bonds and they have a 5% interest rate, you'll earn 5% on the $1,000 for a grand total of $1050. But with the magic of compounding, if you keep going, you'll earn 5% on that, which means you'll earn $1102.50 the next time around—you're earning money on top of money you've already earned. The bigger those numbers get, the more it feels like magic.

Amortization

Your bond investment increases over time—that's all you need to know.

Coupons

In the investing world, coupons refer to the total amounts bonds pay each year. For example, if you had a $250,000 principal in a bond that paid 8%, you'd be paid $10,000 twice a year. (Not bad.) Your coupon would be $20,000, the total amount of the payments.

Collateral

Collateral is the assets that someone puts up to show you that you'll get your money back if you're offering them a loan. For example, the collateral on your mortgage is your house. If you don't pay your home loan, the bank can take your house away.

Some bonds are asset backed, which means that the company promises to sell specific assets if they ever go bankrupt so that you get your money back.

Yield

Yield refers to the cash you're getting from your bond. There are actually two types of yields you might run into: current yield and yield to maturity (YTM).

You can find out the current yield by dividing the annual interest rate on your bond by the current price of the bond. The number helps you see what you'll earn on the bond so that you can figure out what you'll earn if you sell it soonish (within the next twelve months or so). Bond prices are always changing; they might go up if a company is doing well or they might head down if the CEO of a company has a love child with an alien race. Knowing what your current yield is can help you decide whether you'll lose money or earn money by selling now.

Or maybe you can just wait for the love child scandal to blow over. To see whether it makes sense to hold onto the bond, you can tally up the yield to maturity. It's a more complicated calculation (you'll need an online yield calculator or your favorite lovable math nerd for this one), but it will show you how much you can expect to earn from your bond if you hold onto it.

Bond at a Discount

If a bond is selling less than the value assigned to the bond by a government or investor, it's selling at discount. It's great if you want to buy and not so great if you own a bond that's sinking in value.

Bond at a Premium

Sometimes, a bond's credit rating will improve or a bond may suddenly look more attractive to investors. When this happens, people may be willing to pay more than the stated value (that's the value assigned to the bond) to get their grubby mitts on it.

Bond at Par

Bond at par is a bond selling at its stated value (the value assigned to the bond). Bonds at par have yields and coupons that match exactly, and they trade at face value. In the real world, bonds at par are rare unicorns because interest rates and the value of things in general (including bonds) are always changing.

Credit Rating

The credit rating is the history of payments and repayments of a company, meant to show whether the company can be trusted with your cash. Companies like Standard and Poor's and Moody's take a look at the companies issuing bonds so you don't have to (thanks, dudes). They go through all the boring paperwork and grade companies (and their bonds) to decide how good a bet the bonds are.

Bonds from companies that are very likely to repay their bonds with interest get triple A or double A ratings. Companies that have CEOs with embezzling problems and bankruptcy filings (oops) will get low grades. Bonds that have ratings of CCC or lower are sometimes called junk bonds. Not very nice, but that's Wall Street for you.

Bond Risk

How likely is the company issuing the bond to pay back the principal and the interest of the bond—and do so on time? Bond risk will decide how much interest a bond gets and how high the price of a bond is. The federal government, backed by your tax dollars, is considered to have the lowest bond risk out there so you'll earn less interest (but you're also less likely to lose your shirt).

Do you really need to know all these terms to invest in bonds? Probably not. But understanding the risks and knowing what your financial planner is talking about can help. Plus, it makes you sound cooler at dinner parties.

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