Friday, December 30, 2016

Bond Basics: Part 3

In Part 2 of this series on bond basics I explained the relationship between bond price and bond yield: when one goes up, the other goes down. However, I also stated that saying when interest rates rise, bond prices fall (or vice versa) is not really an accurate statement. This is because there are many different interest rates in our economy, and the price of a bond is only affected by the interest rate, or more precisely the yield, of that particular bond or bonds very similar to it. Below I'll discuss the precise relationship between the price and yield of a particular bond a bit more, then explain why the relationship between interest rates in general and bond prices in general is not so precise.

Wednesday, December 28, 2016

Bond Basics: Part 2

In Part 1 of this series I described how a bond is basically a loan, or more precisely, the contract defining the terms of a loan, where you are the lender and a company or government entity is the borrower. I explained that the terms of this loan contract, or bond, include the principal amount, referred to as the face value, an interest rate, referred to as the coupon rate, a payment schedule for the coupon payments, typically every six months, and a due date for the final coupon payment and repayment of principal, referred to as the maturity date.

Toward the end of Part 1 I introduced the concept of yield to maturity (YTM), often simply referred to as yield. A bond's yield incorporates both the coupon rate and the change in bond price between the day you buy the bond and the day the bond matures. A bond's yield provides a reasonable measure of the rate of return you can expect for a bond held to maturity. I explained that the market price of a bond may be different than the face value of the bond, that bond yield is inversely related to bond price, and said that I would explain all of this with an example in Part 2. Read on for the explanation.

Thursday, December 22, 2016

Bond Basics: Part 1

One of Warren Buffett's famous maxims is, "Never invest in a business you cannot understand." I would expand on this to say that you shouldn't invest in anything you don't understand. An annual National Financial Capability Study has found that only 28% of American adults understand the relationship between interest rates and bond prices, yet bonds comprise one of the major asset classes that most investors own. My goal in this blog post series is to aquaint you with the basics of bonds so that you can make informed decisions about including bonds in your investment portfolio.