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Bond Basics: When interest rates increase, existing bond prices fall.

I have been invited to countless conference calls, webinars, and conferences that promise to educate me about the outlook for municipal bonds. However, in all of that noise, some of the most important but least understood implications for today’s bond market are being overlooked by many investors.

Here are some bond basics that investors should be aware of:

Why do bond prices move?

Bonds are a very simple financial instrument: They are loans. As with all loans, bonds pay an interest rate to entice investors to lend money. In the bond market, these interest payments are called coupons. In general, coupon payments are fixed and have set schedules (annual, semi-annual, quarterly). But, while these coupon payments are static, the interest rates investors in the market demand for their investments are not.

Bond Basics: A simple example

Assume that you buy a $1,000 (par value) bond, which pays a fixed coupon of 5 percent and matures in 10 years. You would be entitled to a $50 annual interest payment and (assuming no defaults) a $1,000 principal payment ten years in the future.

Now, fast forward one year, and assume the interest rate in the market has risen from 5 percent to 10 percent. Interest rates and bond prices are inversely related—as interest rates rise, bond prices decline. If you wanted to sell the bond you purchased last year for $1,000 to another investor, investors would demand that you match the market rate of 10 percent. However, for your bond’s coupon rate to make a 10 percent interest payment, another investor would only be willing to pay $500 for your bond (your $50 coupon is 10 percent of $500).

In this simplistic example, you now own a “discount” bond—your bond would be trading below or at a discount to the initial par value. Because of this fluctuation, you may end up with more or less than what you originally paid for the bond, unless you hold it to maturity.

Premium vs. discount bonds

As with most everything in the bond markets, the terms “premium” and “discount” are relative. As referenced above, your bond would be referred to as a “discount” bond if the current value an investor would be willing to pay in the market is below the original issue price or “par value.” Alternatively, if the market value of your bond is above the original issue price it would be a “premium” bond.

Is a premium or discount bond better?

There are benefits and drawbacks to each price condition. For discount bonds, you have the benefit of likely seeing appreciation of the price of your bond. In other words, if a bond was issued at $1,000 and you were to buy it for $900, you would realize a $100 or 10 percent capital appreciation to maturity, assuming no default.

However, there are cases in which buying a premium bond can be advantageous. Suppose you buy a bond for $1,100, which you know will mature at $1,000 in the future, assuming no default. You are essentially assured to receive 10 percent less than you paid for the bond. However, if you are a taxable investor, you may also realize a meaningful tax savings by deducting that capital loss from other capital gains realized in the same tax year.

In today’s bond market, there are bonds trading at discounts and bonds trading at premiums. A simple calculation used to compare these bonds is called “yield to maturity.” This calculation effectively normalizes the income and principal payments you would receive from a bond investment over the remaining life of a given bond. Given the relatively low interest rates in today’s markets, many bonds are trading at premiums.

It is important to understand how those premiums affect your total return between now and the eventual maturity date of the bond in question. There are situations in which it makes sense to hold or to purchase bonds trading at either a premium or discount, but that goes beyond “bond basics” — most investors are not familiar enough with the complexities of bond mathematics to determine which would be best for them. Consult a qualified professional to ensure that you are getting the best option for your portfolio.

Read the article on U.S. News & World Report here! >

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Strategies involving asset allocation and diversification do not ensure a profit or protect against a loss.