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Understanding How Bonds Work

Apr 17, 2008
Before investing in bonds, you must understand some things about bonds. Understanding what kind of bonds to purchase, what maturity date to purchase, is necessary before you begin to invest in them. Par value, maturity date and coupon rate. These three characteristics of a bond are the most important things to consider before purchasing a bond. Buying a bond without thoroughly studying these characteristics of a bond is the surest way to make the wrong decision.

The par value of a bond refers to the returns on your investment once the bond matures. It is the amount of money that you will receive at the maturity date. In other words, when buying a bond, it is important to note that you will be receiving your entire investment plus interest only at the maturity date. This is the bond's par value.

Naturally, the maturity date refers to the date that your bond reaches its full value. This is the date that you receive all the returns of your investment. However, when purchasing corporate, state and local government bonds, you do not need to wait until the maturity date before you obtain the money back. Such bonds can be 'called' before they reach the maturity date. When the bond is called, the corporation or government issuing the bond will return your investment as well as any interest your bond has earned up to that point in time. However, federal bonds are unable to be 'called'.

The coupon rate refers to the interest rate. This determines the amount of money that you will receive when the bond matures. This is specified as a percentage. For example, a bond with a $1000 par value with a coupon rate of 10% will earn an annual interest of $100 until the bond matures. Similarly, a bond with a $2000 par value and a coupon rate of 5% will also earn an annual interest of $100 until the bond matures. This is important to note as the different bond value means a different initial investment, even though the annual interest is the same.

However, many people still do not understand how to purchase a bond. This is because bonds are not sold by banks, but rather by the government. This makes things slightly more confusing for most people. However, there are two ways of buying a bond.

The first way, is to go to a broker or a brokerage firm. The broker is able to make the purchase from the government on your behalf. However, you are likely to be charged a commission fee. Shopping around for the lowest commission fee is prudent if you want to use a broker.

On the other hand, you can purchase bonds directly from the govnerment. This process, although more troublesome is not nearly as difficult as it used to be. With the introduction of the program called Treasury Direct, all your bonds can be purchased and held in one single account that you have easy access to. If you choose to buy directly from the government, you can avoid using a broker and thus saving on the commission.
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