To help you get you head around bonds, Market Index recently launched a series of articles on bonds within an Australian context.
In part I we talked about making sense of bonds, shades of risk, how the bond rate is set, and how long you need to lend your money for.
In Part II we’re going to look at the three basic options for having your interest paid, and what happens if you decide to ask for your money back early (aka before maturity).
Remember, when it comes to bonds, it’s you that’s doing the lending - typically to fund government or corporate activity – and there are different ways in which you can receive interest from doing so.
There are three types of interest you can be paid.
Fixed Rate: For example, a fixed rate when the bond is issued stays the same, assuming you hold the bond until the maturity date (aka the time-frame you’ve agreed upon to lend your money out).
In technical language, these interest rate payments are referred to as a fixed coupon rate (aka the yield paid by a fixed income security) and represents the yield the bond offered on its issue date.
Floating Rate: There are also floating rates, which by definition can go up or down over the term of the bond. With floating rates, the coupon payments you receive are based on an underlying interest rate, plus a specified percentage or margin.
It’s not rocket science, your coupon payments (on a floating rate) will rise if interest rates go up and fall if they go down. Once the pre-determined length (aka the duration) of the loan ends, the bond issuer will repay you back the original amount they borrowed from you.
Indexed Rate: Then there are indexed bonds where the coupon payments (and the face value) increase in line with changes in the consumer price Index (CPI), hence offering protection against inflation.
While it can be argued that most floating rates equally offer protection against inflation, fixed coupons do not.
In the event that you decide to sell your bond on the secondary market before maturity, there’s no guarantee you’ll receive what you paid for it.
If you sell a bond before maturity you’ll have to settle for the market value, which depending on market interest rates and supply and demand, could be more or less than what you paid for it (the face value).
The demand for a bond on the secondary market will be determined by a number of factors, including the bond's maturity date, yield, and the coupon payments left to be paid out.
If you have no specific maturity date in mind when investing in bonds, the market will typically indicate what duration will complement the best outcome.
For example, during a period of economic downturn, long-term bonds tend to complement a period of declining interest rates, and vice versa.
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