Purchasing bonds by owning a bond fund is straightforward compared to selecting individual bonds. Few average investors can analyze bonds, so a large proportion purchasing bonds obtain a mutual fund called a bond fund, and let professional money managers make the selections for them. Hence, when you own a bond fund you own section of a professionally managed portfolio of bonds, often called an income fund.
Don't get confused. Purchasing bonds or an income fund has little in accordance with buying U.S. Savings Bonds. The federal government guarantees you will not lose profit savings bonds. There is no market risk in these savings products. When investors talk about bonds they are not talking about savings bonds. invest in premium bonds
A connection fund may also be defined as an income fund, because the principal objective is to provide higher income vs. other investments. These funds pay dividends from the interest earned on the bonds in the fund portfolio. Along with this specific higher income, purchasing bonds involves risk. Bond prices or values fluctuate because bonds are marketable securities that trade in the open market, similar to stocks do.
In order to understand purchasing bond funds, you first should try to learn some bond basics. Let us turn our attention now to a simplified bond example, a new problem of a really basic corporate bond.
ABC Corporation decides to raise a sizable sum of money to expand their operations. Rather than selling stock to the public, they decide to sell bonds. In other words, they will borrow money from investors. Each bond has a face value or initial bond price of $1000. The coupon rate will be 6%. These are top quality bonds and mature in 2039. Once all of the bonds are sold ABC gets their money, and these bonds commence to trade in the bond market.
If you purchase an ABC bond for $1000, ABC promises to pay you $60 per year, or 6%, for provided that you own it until 2039 when the bond matures. During those times the bond owner gets the $1000 back, and the bond no more exits. Up until that point the deal never changes. ABC promises to pay the bond owner $60 per year, period.
You as a bond holder are not required to keep the bond until 2039. You are able to sell it at will on the bond market, or buy more bonds at market price in the event that you wish. But beware that bond prices fluctuate, as do stock prices. Bond prices or values can rise and they could go down. In other word, a $1000 bond is certainly not worth $1000 after it's issued. Hence,there's market risk involved when purchasing bonds.
Now picture an income fund invested in a portfolio of bonds similar to ABC bonds. Since this bond fund holds a wide variety of different bonds, investors need not be worried about a company like ABC going broke and not making interest payments or not paying investors back upon maturity. The fund is broadly diversified.
The true risk you need to be aware of when purchasing bonds and bond funds is of a different nature, and this risk is known as interest rate risk. Interest rates in the economy fluctuate, but a bond's coupon rate does not. ABC bonds, as an example, pay $60 per year, period.
What goes on when long haul interest rates in the economy rise? Simply this: the worth of existing bonds, in other words bond prices, go down.
View it this way. If interest rates double and go from 6% to 12%, new bonds will be paying investors $120 per year in interest vs. $60. What do you consider investors in the bond market would be willing to cover a 6% bond under these circumstances? Since investors buy bonds for the higher interest they feature, the price of our 6% bond will fall such as for instance a rock. The bond price will not likely fall by 50 percent, but it will be heading because direction.
Interest rates peaked in 1981-82, and have generally been falling since. Despite our above example, falling interest rates send bond prices higher. Investors in bonds and bond funds get income from interest or dividends when interest rates fall, plus the worth of their investment increases.
But interest rates can not fall forever. If they do head north again many folks invested in bond funds or income funds will be caught standing flat footed. Invest informed and understand this: When interest rates rise significantly, the worth of your bond investments will fall.
A retired financial planner, James Leitz posseses an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly using them helping them to attain their financial goals.
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