Making Money by Investing in Bonds
Protect your nest egg by incorporating these stable investments.
For the completely new, totally inexperienced investor who doesn't know anything about fixed income investing, there are two primary ways for bond investors to make money. Here's how an owner of a bond can make money from holding it in his or her investment portfolio.
#1: Collect Interest Income
When you buy a bond, you are loaning money to the issuer. Sometimes, the bond issuer is a corporation (corporate bonds), other times a government or municipality (sovereign or municipal bonds). The interest rate, or the coupon rate, is determined by the general level of interest rates at the time, the maturity of the bond, and the credit rating of the issuer. If you buy a $1,000,000 bond from Coca-Cola when it is issued, and the coupon rate is 7%, you should collect $70,000 per year in interest income.
If the maturity is 30 years in the future, you will receive your original $1,000,000 investment back 30 years from the date the bond is issued. This could be a great deal for you, because you get money to live on and pay your bills, and a great deal for Coke, because they can use the money to build new facilities, expand their product line, buy bottlers, or meet other needs.
#2: Generate Capital Gains
Many bonds are not held until maturity. Investors need money back before their bonds mature so they sell them through a broker. When that happens, you might earn a capital gain or experience a capital loss depending upon what has happened to the credit quality of the issuer (e.g., if the company that sold you your bond has gone from being incredibly healthy to on the verge of a bankruptcy filing, you are only going to get pennies on the dollar because other bond investors aren't going to be willing to take the chance unless they are paid a high rate of return).
Likewise, if interest rates have increased, your bond will have lost value because investors will demand you give them a higher return than the coupon rate. That is, if you buy your Coke bond yielding 7% and suddenly comparable bonds are yielding 10%, you are going to have to lower your price until your bond is yielding 10%, too. Otherwise, why would anyone buy it when they could just buy a newly issued bond for a higher yield? On the other hand, if bond rates fell, you could sell your bond for a higher price, earning a capital gains profit.
To understand the relationship between making money in bonds and interest rates, read about a concept known as bond duration.
More About Investing in Bonds
If you are interested in adding fixed income securities to your life, here is some more information to help you understand the lay of the land.
- What Is a Bond? Get the basic definition of a bond, an overview of where certain bond terms (such as coupon) originated and discover a list of different types of bonds you might consider owning.
- Investing In Bonds 101 A sort of narrative hub that takes you through dozens of articles I've written related to bonds and bond investing, this is a great way to learn if you want an overview as if we were sitting across from one another, having coffee. Each link will take you to a more in-depth article on that particular bond topic.
- How Much of My Portfolio Should I Invest in Bonds? Getting the asset allocation of bonds right is a big deal. Think about it carefully.
- Investing in Corporate Bonds Discover what makes corporate bonds different from other bonds and why they are appropriate for certain types of investors.
- Investing in Tax-Free Municipal Bonds One of the most popular investments in the United States, a well-selected tax-free municipal bond can provide interest income that is free from Federal, state, and local income taxes. Let me teach you the two different types of municipal bonds and how to calculate taxable equivalent yield to compare municipal bond yields to other non-tax-free bond yields to see which might be the better deal for you.
- Investing in Savings Bonds This is a central hub linking to tons of articles on United States savings bonds, including to sub-hubs on Series EE savings bonds and Series I savings bonds.
- The Dangers of Investing in Junk Bonds It might seem link junk bonds are a good way to make money investing in bonds but you'd be mistaken. Despite their seductive yields, they almost always end in tragedy for individual investors who don't know what they are doing. Instead, read "How Investment Grade Bonds Can Help You Avoid Credit Losses" and if you're feeling especially conservative, look into Triple A rated bonds.
- The Dangers of Investing in Foreign Bonds If you don't know what you are doing, or you aren't working with a respected asset management company operating within your defined risk tolerance, run! These are not for you between the myriad of risks they present, ranging from political risk to currency risk.
- How Bond Spreads Can Cost You a Lot of Money Pay close attention to bond spreads when buying or selling any type of bond that can be traded. The gaps between the bid price and the ask price can be significant.