How to Evaluate Bond Issues and Interest Rates
When simplified, investment markets can be divided into two types: equities and debt. Equity investments are purchases of shares in a company and represent a part of the ownership of the company. Shareholders may or may not receive annual dividends. Debt investments, on the other hand, represent a loan to the company with the corresponding return plus expected interest. A bondholder is entitled to regularly scheduled interest payments. Investments in debt are considered a bit safer than stocks, but there is risk associated with any investment.
Debt investments are commonly known as bonds. The bonds can be issued by federal, state, and local governments, as well as corporations. There are advantages and disadvantages with both. For example, if you invest in a federal bond issue, the interest income you receive on this investment is generally not subject to state and local tax. Similarly, state and local bond issuance interest income is generally not taxed at the federal level. Corporate bond interest income is taxed everywhere.
It’s a good idea to get an interest rate education before investing in debt instruments. In the United States, the Federal Reserve Bank (or the “Federal Reserve”) sets interest rates. They do it in a meeting that is held every six or eight weeks in which the national economy is evaluated. They then decide what to do with the interest rates. This decision is based on many factors, but mainly on the rate of inflation that is being experienced.
If inflation is increasing, the Fed can raise interest rates. This makes the money supply (in the form of loans) a little tighter and harder to come by, which in turn curbs inflation. If there is no or very little inflation, interest rates will likely remain as they are. If there is deflation, or a slowing economy, the Fed may try to stimulate it by lowering interest rates, allowing more people to borrow, thereby stimulating the economy.
The reason you need to know what is happening to interest rates before investing in bond issues is because bond prices are directly related to currently available interest rates. In general, if interest rates are going up, the price of bonds is going down and vice versa. Of course, this means next to nothing if you intend to hold the bond until maturity. This is notable only if you, like most bond investors, tend to hold it for less time, selling it before maturity. So if you sell a bond before maturity during a period of rising interest rates, the bond’s value may be less than when you bought it.
The main characteristics of a bond issue that you should know about are:
Coupon Rate – This is the interest rate that will be paid to you on this loan. You also need to know when it is paid. Usually this is once or twice a year on specific dates.
Due Date: This is the date the loan is due and payable. On this date, the company will repay the capital it loaned you.
Sight Provisions: Some bonds have the right of the borrower to repay the loan proceeds early. Some cannot be called. Those that are redeemable are generally repaid at a higher price than what you originally paid when the early option is exercised. Note that when a bond issue is due and interest rates are falling, the company will often find it financially advisable to buy back its bond with proceeds from a new bond issue at the new lower rates.
The biggest risk in investing in bonds is that the issuer will go out of business. This is why federal bonds are so popular; There is virtually no chance of the federal government going out of business! Federal Treasury Bonds are among the safest investments you can make. Corporate bonds, however, are a different story. Any company can fail for various reasons. If you have an investment in company bonds when this happens, your investment is almost worthless almost immediately. However, bondholders HAVE priority over shareholders and will be paid first. Senior bondholders can even claim physical assets after company liquidation.
Bonds are a pretty safe investment as long as these risk factors are taken into account. A good mix is recommended if corporate, federal and local government bonds are recommended. Even launching some junk bonds with high interest rates could be profitable. Diversification reduces risk, even in the bond market.