A Story Relating To Some Aspect Of The U.S Government How to Evaluate Bond Issues and Interest Rates

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How to Evaluate Bond Issues and Interest Rates

When simplified, the investment market can be divided into two types: equity and debt. Equity investment is the purchase of stock in a company and represents ownership of a part of the business. Stockholders may or may not receive annual dividends. Debt investment, on the other hand, represents a loan to the company with an associated return and expected interest. A bond holder is entitled to regular fixed interest payments. Debt investments are considered a little safer than stocks, but there are risks involved with any investment.

Debt investments are commonly known as bonds. Bonds can be issued by federal, state and local governments as well as corporations. Both have advantages and disadvantages. For example, if you invest in a federal bond issue, the interest income you receive on this investment is generally not taxable at the state and local level. Similarly, state and local bond issue interest income is generally not taxed at the federal level. Corporate bond interest income is taxed everywhere.

It is a good idea to learn about interest rates before investing in debt instruments. In the United States, the Federal Reserve Bank (or, the “Fed”) sets interest rates. They do this at a meeting held every six to eight weeks where the national economy is assessed. Then they decide what to do with interest rates. This decision is based on many factors, but primarily the rate of inflation being experienced.

If inflation continues to rise, the Fed may raise interest rates. This makes the supply of money (in the form of debt) somewhat tighter and harder, thereby reducing inflation. If there is no or very little inflation, interest rates will likely stay the same. If there is inflation, or a sluggish economy, the Fed can try to stimulate it by lowering interest rates, allowing more people to borrow, therefore stimulating the economy.

Before you invest in bond issues you need to know what is happening to interest rates because bond prices are directly related to the current available interest rates. Generally, if interest rates are rising, bond prices are falling and vice versa. Of course it means nothing if you want to hold the bond to maturity. This is only significant if you, like most bond investors, tend to hold it for a short period of time, selling it before maturity. So if you sell a bond before maturity during a period of rising interest rates, the value of the bond may be lower than when you bought it.

Key features of a bond issue that you need to know:

Coupon Rate – This is the interest rate that will be paid to you on this loan. You should also know when it is paid. Usually it happens once or twice a year on certain dates.

Maturity Date – This is the date the loan becomes due and payable. On this date the company will return the capital you lent them.

Call provision – Some bonds carry a right to the borrower to repay the loan early. Some are non-callable. Callables are usually returned at a higher price than you paid in principal when exercising the put option. Note that when a bond issue is callable and interest rates are falling, the company will often financially advise you to buy back your bond with the proceeds from a new bond issue at a new lower rate.

The biggest risk in bond investing is that the issuer will go out of business. This is why federal bonds are so popular; There is virtually no chance of the federal government going out of business! Federal Treasury bonds are among the safest investments you can make. Corporate bonds, however, are a different story. Any company can go out of business for any reason. When this happens when you have an investment in a company’s bonds, your investment is worthless almost immediately. Bondholders have priority over DO stockholders, however, and will be paid first. Senior bondholders can even claim physical assets after the liquidation of the company.

Bonds are a good fairly safe investment as long as you factor in these risk factors. A good mix if corporate, federal and local government bonds is advised. Even throwing in some junk bonds with high interest rates can be profitable. Diversification reduces risk, even in the bond market.

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