If bonds are you loaning money to someone (the govt.for example), and you know the interest rate that u'll get the principal + interest with in a few years, then HOW DO PEOPLE LOSE MONEY IN BONDS?
what makes bonds risky if its fixed interest rate? Maybe this defintion is not really correct, so help me!
Thanks it has to do with what is called the "Secondary Market". you won't lose money if you hold a bond until maturity, but many kinds of bonds can be sold to someone else before maturity.
let's say you bought a 10-year $10k bond right now that pays 5%/year, or $500/year. it happens that interest rates goes up to 10% 5 years later, but you need to sell your bond for whatever reason. but your bond is now worth no more than $5k to anyone else, because they can now invest $5k anywhere else and make 10%, or $500/year.
if the interest rates went in the opposite direction, down, then you will make more money on your bond if you sell early. they lose money in bond FUNDS, not bonds.
the risk is this...say you get a bond at 8%. if interest rates go up to 10%, you are still only getting 8%. If they go up to 20%, you are still only getting 8%.
people lose money in bond funds when interest rates go up because the bond funds must sell funds from time to time...if they are selling a bond paying a lower interest rate, no one wants to buy it, so they have to lower the price. The biggest risk is TAKING NO RISK. If you buy $1000 bond that pays you $1045 dollars at the end of the year, and during that same year the broader stock market rose 20%, instead of making $45, you could say that you LOST a potential $155!
People also "trade" bonds that have not reached maturity, which is another way to lose money. Although the interest payments on bonds are fixed, bonds can still lose market value when the market rate of interest exceeds the interest rate on your bond. As such, if interest rates move against me in this way and I go to sell my bond, I will take a hit.
For example, let's say I buy a 30-year bond for $1000 that pays 5% interest per year. Next year, the interest rate for such bonds moves to 10%. I'm still just getting 5% for my bond; the interest payments are fixed. Let's assume that the transmission in my car craps out and I need money right now, so I go to sell my bond.
If the market rate of interest is 10% and my bond only pays 5%, would anyone pay par value ($1000 in this example) for my bond? Of course not! Rather, people would want to buy my bond at a discount. The exact amount that I would be able to sell it for is some amount that would make the cashflows from my bond ($50 per year) equal a 10% return to whomever buys it. For example, $50 per year is a 5% return if you pay $1000 for the bond, but 10% return if you only pay $500 for the bond.
One can also lose money in a more abstract way due to the "opportunity cost of interest." Basically, if I buy a bond that yields 5%, and then interest rates moved up to 10% tomorrow, I have already tied up my money and have thus lost the ability to avail of the higher interest rates. However, this is more theoretical than practical and wouldn't show up on a balance sheet or anything. There are bond funds and individual bonds which I what I think you are referring to.
The interest payments and principal payment at maturity are "guaranteed" but that is a relative term. It has to do with the credit rating or quality of the bond. There are different investment research firms (i.e. Morningstar) which rate a bond's quality with a proprietary scale. The interest payments are fixed but your yield changes as the bond's face value changes. You will get the same amount of interest payments but you could sell at a loss if it is a junk bond.
It is very possible to lose money on bonds not only because of market fluctuations but also because of the debtors (bond issuer) financial health. If a company which issues a bond goes bankrupt for example, those interest payments go away of course and it will be difficult to get your principal back.
Bottom line is that bonds are safer than stocks but are still dependent on the market, overall economy and bond issuer management. Also it is legal and has happened when a company calls (buys back) the bond it issued BEFORE the maturity date which means to you less interest payments.
If you talk about US bonds (or notes or bills) then the issuing "company" credit rating is almost perfect that being the US government (state or federal). The day they go bankrupt or call the bond early you will have more important things to worry about then money (also say goodbye to your FDIC insured bank accounts).
Check out this great tutorial from investopedia.com:
http://www.investopedia.com/university/b...
My $0.02 People lose real (as opposed to theoretical) money if they are selling their bonds BEFORE MATURITY for less than they paid for them.
Par for most bonds is $1,000. The interest that is paid is always based upon PAR. A 6% bond will always pay $60 per year no matter the value of the bond. It is fixed at that coupon rate.
For various reasons the value of the bond will change. When this happens, then the YIELD (different from coupon/ interest rate) will change. YIELD is what investors are really comparing.
That consistent $60 annual interest yields:
6.00% if I buy the bond for $1,000 (60 / 1,000).
5.45% if I buy the bond for $1,100 ( 60 / 1100).
6.66% if I buy the bond for $ 900 ( 60 / 900).
If interest rates rise to 7.5%, the interest paid on a new issue bond will be $75 ($1,000 * .075). For a yield of 7.5%. For them to be interested in my bond paying only $60 it must yield to them at least 7.5%. They will not pay $1,000, they will only pay $800 ($60 / .075).
I bought the bond for $1,000 and if I selll it today I will collect only $800. $200 loss. Of course I can hold it to maturity and continue to collect $60/year and the full $1,000 at maturity.
Corporate and Municipals have Default risk. They are therefore riskier than Govt bonds and Yield a bit more, but of course can default and stop paying you.. Therein is a huge risk.
Hope that makes sense. Sometimes someone needs the money sooner then the borrower is required to repay and has to sell the bond at a loss. This can happen with any bond, including government ones.
Sometimes, the borrower does not pay when they agreed. This often happens with corporate bonds if the corporation goes bankrupt. It rarely happens with local government bonds. It does not happen with U.S. government bonds. There was doubt that some bonds used to pay for the revolutionary war would be paid, but those were eventually paid while George Washington was President (and that was over 200 years ago). |
