When interest rates were high 30 years ago, a low risk investment involved buying a CD with a life of several years at a guaranteed rate of return. Your principle was locked up for the time period, however was safe. CD’s are still available, however the interest rates are so low that they are not interesting to most people.
Several strategies are available for people who would like a guaranteed income stream from a market investment. One is to invest in dividend paying common stocks. While you will receive quarterly dividend payments, your initial investment will grow or shrink depending on the stock price. Also, dividends are not guaranteed. In a bad business climate, not only may the stock price drop, but the dividend may be cut or disappear.
Bonds are another way of getting an income stream. Instead of owning a company, you are lending them money and therefore have a safer investment…but not risk free. Bonds are rated by rating agencies and therefore you can have a good handle on how much risk you may be taking on. Triple A bonds are from blue chip companies to government bonds and are relatively safe, but will yield lower rates. Junk bonds have more risk, and you will be rewarded with higher interest payments. Municipal bonds are instruments issued by cities, counties and states and are free of federal taxes and often state taxes. Because of the tax benefit, the interest rates will be discounted. These only really make sense in taxable accounts and not IRA’s.
If you look to buy a bond, you will be confronted with a number of fairly simple numbers that will describe the bond:
Price of the Bond: Bonds are generally issued with a $1000 face value. If you hold the bond to maturity, this is the amount of money that you will receive. However, bonds will sell at a discount or premium to the face value depending on market conditions, age of the bond and interest rates.
Maturity: Bonds have a fixed life span which is set when the bonds are issued. 30 years is a typical maturity for a new bond. As bonds can be traded at anytime during their life, it is possible to buy or sell bonds with any number of years left on their maturity. The value of the bond will reflect the remaining life as well as the interest rate market.
Interest Rate: The interest rate normally quoted on a bond will be the interest when issued and reflects interest to be paid on the $1000 value. The effective interest rate will be the rate that you will receive based on the price you pay for the bond.
Callable?: Many bonds can be redeemed or called by the issuer before the maturity date. There will be a statement attached to the bond indicating that the bond is callable after a certain date. There is no guarantee that a bond will be called. The issuer will buy back the bond at the initial $1000 price. In a rising interest rate environment the bond probably will not be called.
One thing to remember with bonds is that the price of the bond is always going to move in the opposite direction from the interest rates. As rates rise, bond values will drop. However you will always get the same payout at maturity.
For more information contact Wolcott Financial Solutions.