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Understanding the $38 Trillion Bond Market in 5 Easy Steps

Understanding the $38 Trillion Bond Market in 5 Easy Steps

When it comes to the holy trinity of investing, (stocks, bonds and cash) it seems the rules and nuances of investing in the bond market often are the most baffling for newcomers.

For this edition of Investing 101 we are going to demystify the bond market and have put together five quick tips to help you get your head around buying bonds.

1. What is a Bond?

Simply put, a bond is a loan. Just like a mortgage, bonds involve a lender and a borrower, and also come with a predetermined interest rate and maturity date that never changes. And just like you and me, bond issuers also have credit scores (or ratings) that make it more or less expensive for them to borrow depending on the likelihood that the lender will be paid back. Bonds typically are sold in $1,000 increments and have a face value (or par value) in the same amount.

2. How Do Bonds Work?

A bond is essentially a contract between a buyer and a seller in which the borrower (or issuer) agrees to make semi-annual (twice a year) payments to its creditors (that's you) until the agreed upon term is up (the maturity). At that point you get your original investment (or principal) back in one big lump.

The amount of these payments is determined by an interest rate (or coupon) that is fixed for the life of the bond or loan. You may have heard of the term "fixed income" investments before, well now you know it's because your Treasury bond, come hell or high water, will pay the exact same income, a feature that is particularly adored by retirees.

For example, if you bought a 10-year Treasury (^TNX) with a 5% coupon it would pay you $25 every six months for each $1,000 you invested, or $50 a year (5% of $1,000 = $50). Then, after 10 years, the borrower would send you your principal back.

3. How Do Interest Rates Effect Bonds?

Just like credit scores can raise or lower your borrowing costs, changes in interest rates will effect the current value (or price) of your bonds. If interest rates go up, the current value of your bonds will go down. If interest rates go down, the current value of your bonds will go up. This is what is known as an "inverse relationship" --Rates Up = Prices Down or Rates Down = Prices Up. This tends to be the most confusing part of fixed income investing for many people.

Importantly, regardless of the current market value of your bonds, the fixed income that they pay you never changes, nor will the face value returned to you upon maturity. These so-called "paper losses" or "paper gains" would only be a factor if you were to sell your bonds ahead of their due date. Still, it is important for investors to consider interest rate trends before putting money in the bond market.

4. Who Sells or Issues Bonds?

The biggest, most popular bond issuer (borrower) in the world is the U.S. government, which periodically issues (or auctions) new Treasury bonds that carry maturities anywhere from 30 days to 30 years. Corporations, states and cities (municipalities) and certain government agencies (Fannie Mae) also use the so-called credit markets to raise money, as do foreign countries.

Just like real life, some bond issuers are really safe and reliable, while others are wildly speculative.

5. Who Buys Treasury Bonds? Where Can I Buy Them?

We already mentioned how retirees like bonds as a secondary source of safe and predictable income, but all sorts of other people invest in bonds too, including pension funds, risk-averse individuals and people simply looking to diversify their portfolios.

Because of this mass appeal, there are literally thousands of different bonds, bond mutual funds, and fixed income ETFs to choose from and they are widely available through any investment company, or can be purchased directly from the U.S. government via the Treasury Direct service.

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