Understanding the Basics of Bonds
June 23rd, 2010 |
One often hears about the bond markets being the basis of interest rates going up or down, but few really understand what that means. In this article, we take a look at the basic processes involved.
When we talk about bonds, we are not talking about a certain British spy with a licensed to kill. Sadly, they aren’t even remotely as exciting. Instead, a bond is a certificate of debt issued by a government to raise money. In issuing the bond, the government promises to pay back the indicated amount on a certain date at a certain interest rate. It should be noted that corporations can also issue bonds, but we’ll stick with government offerings for the purpose of this article.
The term of a bond can range wildly. There are short term bonds that mature [are paid by the government] in a few months and long term bonds that don’t pay off for as long as 30 years. You can hold these bonds or you can actually trade them in bond markets that work on an auction basis somewhat similar to the stock market.
Buying bonds can be a bit confusing. Most short term government bonds are bought at a discount to the face value at the maturity date. What does this mean in practical terms? It means that you pay less money now for a bigger payoff later. Let’s say you want to buy a $1,000 bond that has a maturity date in one year. You would buy it for a discount set by the market, say $975. The government would then pay you $1,000 in one year.
Longer term bonds are set based by an auction. You can see how this works given the financial strife in Europe. Greece has a lot of debt that many bond investors feel impact its ability to pay its obligations. The only way investors will buy the bonds is if they get a better rate of return. Given this, Greece must pay a higher interest rate on its bonds to facilitate its debt.
Why would someone invest in government bonds? Notwithstanding the problems in Greece, bonds of this type are generally considered very safe. While a company like General Motors might fail, the going belief is a government is very unlikely to have such a problem. This notion is now under attack somewhat given the massive debt levels of countries like Greece, Italy, Spain, United Kingdom, Portugal and, yes, the United States.
Thomas Ajava writes about financial planning for UFCAmerica.com where you can learn more about critical financial planning tools like inflation proof annuities.
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