How to generate passive income. Bonds (Part 2)
That time let's talk about bonds.
What are bonds?
A bond can be thought of as basically a loan agreement. It's a certificate showing that the bondholder has lent a specific amount of money to a corporation or to a government agency and expects to be repaid with interest at some specified date.
If a company needs more money than it can either sell shares or borrow, usually by issuing bonds. More and more companies now issue their own bonds rather than borrow from banks, because this is often cheaper: the market may be a better judge of the firm's creditworthiness than a bank, i.e. it may lend money at a lower interest rate.
Bond-issuing companies are rated by private ratings companies such as Moody's or Standard & Poors, and given an 'investment grade' according to their financial situation and performance, A (low risk) being the best, and С (high risk) the worst, i.e. nearly bankrupt. Obviously, the higher the rating, the lower the interest rate at which a company can borrow.
Most bonds are offered in 1,000-dollar denominations. Others, called baby bonds, come in 500- or 100-dollar denominations. Bonds are not sold singly, however, but in round lots usually of 100,000 dollars. Consequently, the small investor is not the usual bond buyer. Most bonds are purchased by institutional investors: insurance companies, foundations, colleges and universities, and pension funds.
Types of bonds
Among the types of bonds available for investment are: U.S. government securities, municipal bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign government bonds.
Types of corporate bonds:
If a company cannot repay the loans or pay the interest, the holders of secured debentures are automatically entitled to payment from the company's assets. But holders of unsecured debentures are not automatically repaid from the company's assets if the company is unable to pay in the usual way. They can of course go to court to recover their money, but are not treated differently from the shareholders. An unsecured debenture is basically no more than a promise to repay a loan.
The holders of registered debentures are listed in a company register. These debentures can only be transferred in accordance with certain terms and conditions, and every transfer must likewise be entered into the register. A bearer debenture is an unregistered debenture which can be negotiated by just handing it over to the new holder.
Redeemable debentures are repaid on a fixed date or within a certain period of time, often at a higher price than the issue price, which means some extra money for the holder. There is no fixed date for the repayment of irredeemable debentures; the loan is only repaid when the company is liquidated. However, holders of irredeemable debentures may ask the company to redeem them if it fails to keep up its interest payments.
Most bonds used to be issued in bearer form the owner was considered to be whoever possessed the certificates. The certificates could be passed from one person to another. Most bonds now are fully registered: the owner's name is on the certificate, and when it's sold it must be sent to the issuer for a transfer of title. With bearer bonds the interest is claimed by clipping off attached coupons and presenting them for payment to an agent of the issuing corporation or government agency. Registered bonds are more secure. They don't have interest coupons. The interest payments are made by check to the registered bearer.
Bonds have different maturity rates. Short-term bonds mature in from one to five years, intermediate bonds in from five to ten years, and most long-term bonds in from 15 to 20 years. Long-term bonds are not necessarily held to maturity. It's to the advantage of the issuing company to redeem them early. Thus many bonds have a call future: the corporation has the right to call them in and pay a premium over the price at which the bonds are currently selling.
Different kinds of bonds may be categorized according to the use to which the money will be put. Mortgage bonds, for example, are backed by the property of the corporation. Equipment trust certificates are used by railroad and airlines to purchase rolling stock and airplanes.
The many mergers and acquisitions that have taken place since the early 1960s have brought the term junk bonds into prominence. These are loan certificates, issued by corporations that are of less than investment-grade standards. The risk in owning them is balanced against their higher yields. The money that a company gets from selling junk bonds is normally used to retire the debt incurred in an acquisition.
Certificates for very short-term loans are called commercial paper. The loan period ranges from as little as one day to as long as 270 days. Such notes are issued by financial as well as by industrial corporations. Round lots for commercial paper are usually 1 million dollars or more, though smaller units called odd lots are sometimes available.
Yield and Price
All bondholders have two possible variants to increase their investment:
1) they can hold their bonds till maturity, and in such a way they are guaranteed to get their principal back
2) or they can sell their bonds in the open market; but if bondholders are going to sell their bonds they have to keep in mind that bond's price changes on daily bases and sometimes prices fluctuate sharply.
Yield is an indicator that shows the return you get on a bond. It can be calculated in the next way:
yield = coupon amount/price
When you buy a bond at par, yield is equal to the interest rate, but when the price changes, the yield changes as well.
Let's take an example:
If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000 = 10%). If the price goes down to $800, then the yield goes up to 12.5%. It happens because you have to get your guaranteed $100 on an asset that is worth $800 ($100/$800 = 12.5%). Conversely, if the bond goes up in price to $1,200, the yield falls to 8.33% ($100/$1,200 = 8.33%).
The main rule you have to remember if you want to have high yield is that when price goes up, yield goes down and vice versa. In other words, bond's price and its yield are inversely related.
How can high yields and high prices both be good when they can't happen at the same time? If you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, but if you already own a bond, you've locked in your interest rate, so you want the price of the bond goes up. This way you can cash out by selling your bond in the future.
How to buy bonds
Most bond transactions are completed through a full service or discount brokerage. You can also open an account with a bond broker, but the majority of bond brokers need at least $5,000 initial deposit. If you cannot afford to pay such an amount of money, you can look at a mutual fund that specializes in bonds.
Some financial institutions will provide you with the service of transacting government securities. But if your bank doesn't provide this service and you do not have a brokerage account, you can purchase government bonds through a government agency.
If you finally decide to buy a bond through your broker, he can tell you that the trade is commission free. Don't believe! What usually happens - the broker will mark up the price slightly; this markup is really the same as a commission. To make sure that you are not being fooled, simply look through the latest quote for the bond and find out whether the markup is acceptable.
In the end I want to add that you can research bonds just as stocks and be careful, don't give an opportunity to others to fool you!
P.S. For those who are interested in additional information about stock market I can advise to read a book by Jeffrey Little Understanding Wall Street.
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