Bonds are a great way to earn a steady income from your investment, and they are typically a safer place to put your money than stocks. The returns from bonds may not be as high as stocks, but the peace of mind and steady flow of income can outweigh the volatility and upredictability of stocks.
A Bond is defined as a debt security in which the investor loans money to a corporation or government for a set period of time, and in return the investor receives periodic interest payments plus the principal upon maturity of the bond. Bonds are also known as fixed income because the intreste rate (or coupon) is usually fixed. There are three classes of bonds (fixed income): Bills - maturities of less than one year; Notes - maturities between one and ten years; and Bonds - maturities of over 10 years. CD's (cetificates of deposite) are also considered fixed income, and their maturitys vary from a couple months to over a year.
The issue price (or face price) of a bond is the price at which the bond is first sold. This is also called the par value. During the life of the bond it may be traded on the open market or it may be called back by the issuer (only if it is a callable bond). The price of the bond goes up as the demand for bonds increases. For instance, if the stock market is unstable then you may see an increase of money flow from the stock market into bonds, thereby increasing the demand and price of bonds. Conversely, an increase in supply of bonds (hoding demand constant) can decrease the price. For instance, if the Federal Government issues bonds this can increase the supply, which will lower the price of bonds.
Bond prices and interest rates have an inverse relationship: when bond prices go up intrest rates go down; and when bond prices go down, interest rates go up. Many new investors seem to find this hard to grasp at first, but it is actually quite simple. Let's say a bond is issued at $1000 and fixed 5% coupon. Then, the stock market crashes and everybody moves their money into bonds, the price of bonds is going to go up (supply and demand). Let's say the bond is now worth $1200 ($200 above par). The current interest rate would now be lower because the bond is still worth $1000 upon maturity, but the investor had to pay an extra $200 dollars more for it. The coupon rate is still fixed at 5%, but the investor is not going to receive a 5% return because they are already down $200 from buying the bond over par value.
The Feds can manipulate interest rates buy buying and selling bonds on the open market. When the Feds buy bonds, this increases the demand and decreases the supply - which raises the price of bonds. In effect, this will lower the interest rates. And, if the Feds sell bonds this will lower the price of bonds on the market, which will subsequently raise interest rates.
