Features of investing in bonds
The following factors are important if you are going to buy a bond:
- Coupon interest rate: the amount of interest you receive when you buy a bond.
- Due date: the last day of the duration of a bond. On this day you receive the money that you loaned out back.
- Market: the market where the bonds are traded. This is important when you want to sell your bond before its due date.
- Denominations: against what value you can buy a bond. For example, coupons can be handed out in values of 1000 and 5000 pounds.
- Currency of issue: the (foreign) currency the bond will pay you in. This is especially important when you buy foreign bonds because in this case your profits will be affected by the exchange rate.
- Issue price: the price at which the bond is issued. The price can be either below or above the face value. The face value is the amount that you will receive on the due date.
The price of a bond
Bonds can be traded normally on the market for a price above or below the face value. When you want to keep a bond until its due date, the trading price of the bond isn’t of importance; you still get the face value at its due date. However, if you’ve purchased the bond to profit from trading, you need to know how the price is determined.
The price of a bond is mainly determined by the interest rate, credibility and remaining duration of the bond. As the credibility of a bond improves, the value of the bond increases because the risk of the bond decreases. As the end of the duration nears, the price can also increase because there is less risk of negative future developments. The market interest rate is the most important factor of the price of a bond. Take this into account when you start trading bonds!
Market interest rate and bonds
The interest rate of a bond is fixed. If you bought a thirty-year bond a while ago with an interest rate of eight percent, then you will still receive your eight percent. The European Bank adjusts the interest rate regularly to stimulate the economy. A lower interest rate discourages saving behaviour and stimulates spending behaviour.
If the interest rate falls and you own a bond with a higher interest rate than the current market interest rate, the value of your bond will increase. The difference between the profit you will earn on your bond and the interest you will earn on your savings will increase.
If you have a bond with an interest rate of eight percent and the market interest rate is three percent, you make 50 pounds on every 1000 pounds annually. You can decide to sell a bond with a gain or to keep it.
An increasing interest rate will negatively affect the value of your bond. If the market interest rate increases, the demand for your bond will decrease, causing the price to drop. It is therefore of utmost importance to make predictions about the interest rate when you are going to invest in bonds; by doing so you can obtain a high yield on your bond investment.
Earning money with bonds
Now you know how the price of a bond is set; you know you can earn money investing in bonds either by receiving a fixed interest rate over the life-span of the bond or by selling the bond in the mean-time for a profit. Do you already know where and how you can invest in bonds?