A degree in finance isn’t needed to understand interest and bonds. The relationship between these two is not abstract but straightforward. Understanding interest and bonds shouldn’t be difficult as it sounds.
What are bonds?
Organizations, corporations, or governments issue bonds to raise capital. It is an obligation given to the purchaser to repay the money in the future. In exchange, the one who issued the funds will pay interest to the purchaser.
How to issue a bond?
Upon the issuance of the bond, a specific date is indicated. The date in the bond is the maturity date of your bond and can last for as long as 30 years, but there is also a shorter period available. When the bonds are issued, it is then traded into the primary market where dealers can purchase it and in turn, sell to their clients. After that, bonds can also be resold to the secondary market, just like stocks.
Important Factors To Consider When Determining Interest Rates and Bond Prices
There are a lot of factors to be considered when determining the interest rate. Things like length of time until maturity, the creditworthiness of the one who issued, economic climate, and other factors that are hugely associated with bond prices. Different types means different risk profiles.
By the time the bond is issued, the value will fluctuate on the secondary market. As for stocks, Forex Trading you need to have a willing seller before a transaction can take place. You also need a willing buyer who can cope up with the price that you agreed. To say it short, it is the market that sets on the value of a bond.
How To Calculate The Interest Rate of a Bond
The value of your bond is determined by the interest rates. For instance, you own a bond from a certain company worth $2,000 and a coupon rate of 6% plus maturity that goes for 28 years. But the interest rate of the bond has fallen since it was issued. A bond with the same kind of risk can be issued with a 5% coupon rate. For the next 28 years, you will most likely not feel the urge to sell it but only replace the bond with the one that gives you a 5% coupon rate.
Impact of Interest Rates on Bonds
One of the biggest factors to consider when it comes to the sensitivity of interest rates is the maturity time. Consider the example mentioned above. The bond you have still had four years before reaching maturity. The investor who considers purchasing the bond can either acquire lesser or greater interest for the shorter period, not reaching the original maturity date.
The Bottom Line
Typically, corporate bonds are usually invested through mutual funds which are part of the implementation of diversification strategy through asset allocation. As an investor, it is important to understand the risks and gains that you will attain from your investments. If an investor fails to understand the risks, temporary setbacks are turned into a permanent loss.