How To Buy Bonds For Steady Income And Lower Costs

Retirees desire an income they can count on. Bonds are designed for delivering an annual fixed income and payback its face value at maturity. What more is there to know? Actually a lot more.

A company issues its bonds to the public through an investment banker as underwriter of the bonds. These are sold at their face (or par) value - usually of $1,000. The bond pays a constant yearly coupon rate - a fixed payment- that reflects the current interest rate for bonds of similar term (time to maturity). At maturity (perhaps 5, 10, or 20 years), the company buys back the bond from the bond owner at its par value.

Since the underwriter swallows the sales commission in these initial offerings, you get the same price the big investors pay. So, buy them directly from the underwriter whenever possible to get them at wholesale prices.

Buying such bonds from highly rated companies will give you a steady yearly income and eventual return of your money.

But there's a secondary market where you can buy bonds too - but at higher costs. These bonds have already been issues and resold. And within this market, the general trends of bond investments show up. These are that bonds are primarily subject to two major risks:

* Interest rate risk, and

* Credit (default) risk

Credit (or default) risk relates to the possibility that a company default on its bond payments. The higher is this perceived risk, the greater the interest rate that's offered to entice buyers of these bonds.

Inflation's effect is the primary driver of interest rate risk. The more inflation expected, the higher the interest rates that must be offered to entice buyers. That's because at maturity, they'll be paid only the face value of the bond - reduced from its original purchasing power over its term.

As current interest rates increase, the price of bonds in the secondary market must necessarily decrease so their fixed coupon payments divided by their market 'price' reflects the current rate for bonds of similar terms.

If you buy a secondary market bond at a price less than its par value, then you'll receive not only its coupon payments but you'll earn a capital gain when you receive its par value at its maturity.

But the reverse can also happen. If current interest rates have dropped below those for when a bond was originally issued, its secondary market price will be higher than its par value. So purchasing such a bond will pay you it coupon payments, but will earn you a capital loss when it reaches maturity.

So your return from buying a bond on the secondary market is composed of its coupon payments and the capital gain or loss at maturity.

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