Today, I want to discuss something that market analysts don’t talk about too often.
Before your eyes glaze over, this is important.
Bonds belong in everyone’s portfolio. Now, I’m not talking about bond mutual funds or exchange-traded funds.
Today, I want to talk about what you need to know about individual bonds.
First of all, what exactly is a bond?
It’s pretty simple. A bond is a loan that you make to a company or government agency. If we’re talking corporate bonds, then you’re loaning money to a company for a specific amount of time for a specific interest rate.
Bonds are typically sold in $1,000 increments, and they always have a maturity date and a coupon. For example, let’s say there’s a bond that has a 5% coupon and a maturity date of February 1, 2025. If you decide to purchase the bond – meaning you’re lending $1,000 to the underlying company until February 1, 2025 – you will receive 5% per year in interest (which is usually paid in two installments each year). And on February 1, 2025, you’ll get the $1,000 back.
Now, here’s the important part. If you buy or sell a bond in the market, it may not trade for $1,000.
When it is first issued by the company, it will. But as soon as it starts trading, the price will vary.
So you could buy the bond for $900. In that case, you’ll receive more than 5% per year because the 5% coupon is based on the $1,000 figure. No matter where the bond is trading, the bond will pay $50 per year in interest. So if you pay $900 for the bond, you’ll make 5.6% interest ($50 divided by $900 equals 5.6%).
If you pay $1,050 for the bond, you’ll make 4.8% ($50 divided by $1,050 equals 4.8%).
Here’s another important feature: At maturity, a bond pays $1,000, regardless of what you paid for it.
It’s obvious why you might buy a bond for $900 when you know you’ll get $1,000 at maturity plus interest, but you may be asking why someone would pay more than $1,000 for a bond if they know they’ll lose money at maturity.
That’s because even with the loss, they may still make more than they would in other places.
For example, let’s say a bond is trading at $1,050 with a 5% coupon until 2028. Even though an investor will lose $50 at maturity, they will collect $50 in interest per year over the next five years.
When you subtract how much the bond loses at maturity from the total amount of interest paid, that comes out to $200, or an average of $40 per year. That equates to 4% per year. With the market having dropped 8.4% since the start of 2022, investors ought to be very happy earning a safe and secure 4% per year.
One last thing about bonds – and this is really important – is how they differ from stocks.
If you hold a stock for five years, anything can happen. It could go up 10 times, it could get cut in half, it could go to zero or it could go anywhere in between.
While a bond’s price will fluctuate, on the maturity date, the bond will be worth $1,000. The only way it won’t is if the underlying company goes bankrupt.
So you could own a stock that has putrid earnings and falls 40%. But as long as the company is keeping the lights on, regardless of those putrid earnings, its bonds will be worth $1,000 at maturity. The only way you lose as a bondholder is if the company goes under.
That’s a major reason people buy bonds. They earn some income while holding bonds, but bonds stabilize their portfolio. If you buy bonds properly, you can be extremely confident you’re going to get your money back and make money.
— Marc LichtenfeldBetter Than Dividend Stocks? [sponsor]
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Source: Wealthy Retirement