What Is a Bond?
A bond is a loan to a corporation or government. The loan amount is typically in increments of $1,000, and it is for a stated period of time at a specified interest rate. For example, a 30-year bond paying 5% will pay $50 per year in exchange for your $1,000 investment, and will then return your $1,000 at the end of that 30 years. Given the long-term nature of bonds, there is a public market that enables investors to buy and sell these bonds so that investors are not locked in for the full term of 30 years.
The market value of the bond moves inversely with interest rate fluctuations. Hence, if you purchase a long-term 5% bond today and then decide to sell it later, at a time when the market commands a higher interest rate, you will find that the market value of your bond is less than you paid. Hopefully though, you earned enough interest in the interim to offset that loss. On the other hand, if the market is satisfied with a lower interest rate at the time of your bond sale, you will receive a premium above your cost, on top of the interest earnings you already received, resulting in an enhanced investment return.
The following is a simplified example:
Face Value $1,000
Coupon Rate 5%
Annual Interest Earnings $50
If the market demand changes to 6%:
$50 ÷ 6% = $833 market value (a $167 loss)
If you owned the bond for at least four years before selling, your total return would be calculated as follows:
$50 × 4 = $200 + $833 = $1033
A total gain of only $33 on your $1,000 investment is minimal, but at least you didn’t lose money selling in a down market. If, on the other hand, the market demand changes to only 4%:
$50 ÷ 4% = $1250 market value (a $250 gain)
Selling this bond after four years in this market would result in the following:
$50 × 4 = $200 + $1250 = $1450
Here you made a 45% return in just four years, which is far better than a simple 5% per year investment would suggest.
These are very simple calculations to demonstrate the impact of changing interest rates on your investment return using bonds. They don’t take into consideration that these bonds will eventually mature at their $1,000 face amount, so these illustrated market fluctuations are thus exaggerated. To see more detailed calculations that determine “yield to maturity,” ,” see excerpts from the textbook entitled Fundamentals of Investing.
You can make money in bonds—typically not a lot, but a reasonable amount given the low risk associated with them. However, you can also lose money in bonds, especially if you choose to sell them at a time when interest rates have gone up.