Bond Basics

Answer 1

Last time I wrote about asset allocation; specifically the decision regarding the percentage of your portfolio you will allocate to equity versus fixed-income investments. While many people are familiar with the mechanics of equity investing, they may be a bit rusty on fixed-income investing.

First, what does fixed-income investing really mean? Well it differs from equity investing in that you don't purchase an interest or share of any company or other asset of value. You don't end up a partial owner of the company that issued the instrument. Instead you're a lender to them. Just like the bank down the street that issues loans on which interest is due, you've loaned your money to the issuer of the fixed-income investment and you are paid interest. The most common type of fixed-income investment is called a bond.

So you understand that when you buy a bond you're not purchasing a part of the issuing company. But what exactly are you buying? Well, if you could be said to be purchasing anything it is the series of future cash flows that the bond represents. These flows are made up of periodic interest payments as well as the return of your principal at the maturity of the bond. Remember the The Power of Now post about the Time Value of money? That issue plays an important role in regard to bond calculations. When bonds are 'priced' by the market they're done so by calculating the Present Value of the series of cash flows.

Bonds come in many shapes and sizes. They also come from different issuers, some of whom are more likely than others to pay you back. Many have differing tax ramifications, levels of risk, length of term, and may or may not include a lot of miscellaneous bells and whistles. Bond investing is unfamiliar territory to most investors. It's a good idea to familiarize yourself with the overall landscape and it doesn't hurt to seek help from a knowledgeable expert. Happy lending.