Wednesday, January 12, 2011

Making Money With Bonds Investment

Conservative investors prefer to use bonds investment as a primary investment tool to seek for steady and predictable income. They buy a bond when it is issued, keep and hold it until the maturity. In the meantime, they expect to receive regular coupon payments during the term. Once the bond investment term is matured, their investment principle is returned.

Investors who have greater risk appetite may sometimes trade their bonds before they mature, particularly when interests rate fall. When bonds are issued at a high interest rate, the bonds become increasingly valuable when the interest rates fall. For example, a bond investor buys a bond for $5000 when the interest rate is at 5%. If the interest rate falls to 3.5%, new bonds will offer 3% interest rate. The older bond which pays 5% will become more valuable and hence more expensive. On the other way of saying, the bond’s price increases. Hence, this kind of bond’s capital appreciation can generate more return for bond trading investors rather than holding the bond investment into its maturity.

Although bond investment can generate steady and predictable return, there are still some investment risks, namely, the interest rate risk, inflation risk, and default risk.

Interest rate risk
When investors sell their bond before maturity when the interest rates have gone up, the price of the bond will go down to attract buying interest, and eventually incur a capital loss. This is because new bond investors can buy new bonds that offer much higher interest rate. Interest rate risk is one of the three major risks that bond investors face.

Inflation risk
Since the dollar amount investors receive on a bond investment is fixed, the value of those dollars could be eroded by inflation. For example, at inflation of 2%, $100 received in 10 years’s time is worth just $82 today. That’s a loss of $18. In general, the longer the term of a bond investment, the higher would be the interest rate offered to make up for the risk of tying money up for a longer period.

Default risk
This is the risk that the borrower fails to pay investors coupon payment and principle.

Bond investment is one of the best investment options for conservative investors. Its return is steady, predictable and less volatile. However, it is not risk-free. Therefore, being as a wise investor, we may diversify our investment portfolio into different classes of investment assets.

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