Bonds: Key concepts of
Bonds
Interest rate vs. Maturity:
Changes in interest rates don't affect all bonds equally. The longer it
takes for a bond to mature, the greater the risk that prices will fluctuate
along the way and that the fluctuations will be greater-and the more the
investors will expect to be compensated for taking the extra risk. There is a
direct link between maturity and yield. It can best be seen by drawing a line
between the yields available on like securities of different maturities, from
shortest to longest. Such a line is called a yield curve.
It is most commonly drawn for the U.S. Treasury market, which
offers securities of every maturity, and where all issues bear the same top
credit quality. By watching the yield curve, you
can gain a sense of where the market perceives interest rates to be headed-one
of the important factors that could affect your bonds' prices.
There are 3 types of yield curve; normal, flat and inverted
(see the chart below). When
the yield curve is normal or steep, short-term debt
instruments have lower yields than long-term debt instruments. This means you
can get higher yield by buying a longer maturity than you can with a short one.
On the other hand, if the yield curve is flat, it means that the
difference between short- and long-term rates is relatively small. This means
that the reward for extending maturities is relatively small to nothing.
When
yields on short-term issues are higher than those on longer-term issues, the
yield curve is said to be inverted. This suggests that investors'
expect interest rates to decline. An inverted yield curve is sometimes
considered to be a predictor of coming recession. Yield curves generally become
flat or inverted when Federal Reserve pushes up short-term rates to slow down
the economy and to cool inflationary pressures.
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1
10
20
30 years |
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Normal (Steep) Yield Curve |
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1
10
20 30
years |
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Flat Yield Curve |
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1
10 20
30 years |
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Inverted Yield Curve |
Yield vs. Price:
When prevailing interest rates rise, prices of outstanding bonds fall to bring
the yield of older bonds into line with higher-interest new issues. For example,
let's say you bought a new bond issued at 5% interest rate with a face value of
$1,000. What happens if prevailing interest rate rise to 10% after the bond is
issued? New bonds will have to pay a 10% coupon rate or no one will buy
them. By the same token, you could sell your 5% bond ONLY if you offered it at a
price of $500 for the bond producing a 10% yield for the buyer. Thus, you'd lose
$500 if you sell or at least on paper because your bond is worth only $500 now.
It is selling at a discount.
Conversely,
when prevailing interest rates fall, prices of outstanding bonds rise, until
the yield of older bonds is low enough to match the lower interest rate on new
issues.
Because of these fluctuations, you should be aware that the value of a bond
will likely be higher or lower than its original face value if you sell it
before it matures. So remember that as interest rates rise, bond prices
fall; as interest rates fall, bond prices rise.
Tax Issue:
Some bonds offer special tax advantages. There is no state or
local income tax on the interest from U.S. Treasury bonds, and no federal income
tax on the interest from most municipal bonds, and in many cases no state or
local income tax, either.
Do you want income that is taxable or income that is tax-exempt? The answer
depends on your income tax bracket-and the difference between what can be earned
from taxable versus tax-exempt securities-not only presently but also throughout
the period until your bonds mature. Your investment advisor can provide you with
a chart showing how much taxable income you would need at each income tax
bracket to match the return from a tax-exempt security. You may also access a
yield calculator on
Financial Calculator. The decision about whether to invest in a taxable
bond or a tax-exempt bond can also depend on whether you will be holding the
securities in an account that is already tax-preferred or tax-deferred, such as
a pension account, 40l(k) or IRA.
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