As far as financial instruments go … bonds are boring. And confusing.
Maybe that is the point.
Think about it — rate v. yield v. total return.
Wat. Yahn.
Well, rate = interest, or the money the bond is supposed to make.
Yield = a question, or does interest compound? If so, what is the actual interest?
Wat? Yahn.
(un)Simply put, the yield is the amount of interest earned on the bond at the time of purchase.
Coupla different types of “yield.”
“Nominal yield” (or “coupon”) = rate of interest stated on the bond itself.
“Current yield” = rate of interest adjusted by the purchase price.
Example? Buy a $1000 bond for $1100, that pays 7-percent interest and matures in five years, but is callable (i.e., bond issuer can demand return of the bond by paying for it) in two. The price of the bond is $1100 bucks, with the expectation that the buyer will earn $70 every year of the five years of the bond term, or a current yield of 6.36 percent, from the original $1100 purchase.
$70 ÷ $1100 = 0.0636, or 6.36 percent (0.0636 x 100) is the current yield.
The math is mathing.
Anyhoo, another type of “yield” is “yield to maturity,” or the value earned on the investment if the bond is held for the entire term, receiving only the interest payments ($350) for five years and the face value of the bond ($1000) at the end of the five years, resulting in a yield to maturity rate of … math ain’t mathing rn, sooooo … whatevs. The book makes it make sense.
AND and … here’s another little wrinkle … the more frequently interest compounds = the more $###
Example: Figure 3-6, from the book:
Not that I actually understand but kinda but sorta not really but a little bit—PITCHAS!!!
So, looks like considerations to be given when buying a bond is (1) how much interest is the bond expected to earn, and (2) does the interest compound, and (3) if so, how frequently?
Anyhoo, the total return = income +/- changes in principal (cash coughed up in the first) … which is the only term/$### that actually matters. What you get for what you gave … total return on investment.
Yah, that.
Whatevs. Bonds are confusing and boring and necessary for a well-stocked portfolio so find some that work and then … hold on and see what they do.
If interest rates fall, then the value of the bond goes ↑.
If interest rate rise, then the value of the bond goes ↓.
Waitwat?
Yeh … the way it is explained in the book? Think of a seesaw with interest rates at one end and bond prices on the other … when one side rises, the other side falls.
Say you spend/invest $10,000 to buy a bond with a face value of $10,000 at an interest rate of 6 percent and a 30-year maturity. So, if you hold onto the bond for the full term (i.e., 30 years), you’ll get $600 a year.
Two years later, interest rates rise by 2 percent. Now, you still get 6 percent every year, but someone else buying the same bond can spend/invest $10,000 and get an interest rate of 8 percent, or $800 every year. Oops.
So now, your $10,000 bond purchased @6% is not worth the same $10,000 purchased @8%, and if you needed to sell your $10,000 investment, nobody would buy it at face value (á la $10,000).
Gotta drop the price.
So someone would be willing to buy your $10,000 at the lower interest rate of 6 percent, rather than spend that selfsame $10,000 and get an 8 percent rate.
Gotta take a $2500 hit on the selling price …
… according to the book p. 100, that $10,000/6% bond = $7500/8% bond,
… both receive $600 year in income.
Call it “interest rate risk.” All the suck.
BUT but, if you hold onto that $10,000/6% bond until maturity, get what you originally paid for, there is no/minimal hit if don’t sell.
There is that.
AND and, because people with money don’t like to risk their own, a hedge is built into the system to avoid major losses … see: gold.
Gold prices go up with inflation, so if bond value goes down with rising rates, gold acts as a sort of insurance against the loss.
Not really, but kinda. Like everything else in investing.
But hey … go ahead and invest anyway. NOT TEN THOUSAND DOLLARS but try, say hunnert bucks, see how you do.
And go from there.
Gotta start somewhere.
So … start.