How could variations in capital value creep in to the tightly-controlled world of bond investing?
Capital Gains and Capital Losses
Bond investing appears, at first glance, to be immune from changes in capital value. After all, with bond investing there is a fixed amount invested for a fixed term at a fixed interest rate. How could variations in capital value creep in to the tightly-controlled world of bond investing?
The answer lies not within the individual bond, but in the circumstances of the broader bond investing environment.
The moment you fix something, like an interest rate, you create a possible tension between the fixed interest rate of your bond, and the variable interest rate in the wider economy.
Why does this matter?
The world of bond investing can be divided into two parts, and the two types of bond investing are as different as beer and cappuccino. The first type of bond investing involves buying a bond when it is issued, holding it for the duration of its term, and redeeming it at the end of its term. In this part of the bond investing universe, the capital value of the bond between issue and maturity is more or less irrelevant.
The other type of bond investing is more accurately referred to as bond trading, rather than bond investing. In this world, traders buy bond that are partway through their term, and usually they aim to sell them again long before they reach maturity.
The goal of this game is capital gains.
You see, bond investing is all about the fixed income stream. Every month, the bond investor gets a pre-set amount of money, which represents the interest on the capital tied up in the bond.
So, for example, lets look at a bond investment made at an interest rate of 10%. Say the amount of the bond investment is $100,000. The interest payable will be $10,000 per year. Roll the clock forward five years, and now interest rates in the wider market have fallen to 5%. If you took the $100,000 that was tied up in the bond investment and invested it somewhere else at this point, you could only get $5,000 a year in exchange.
To get $10,000 a year, you would have to invest $200,000.
The income stream from your bond investment is actually equivalent to the income stream from an investment of $200,000. This would be of purely academic interest, if it wasn’t for the existence of a secondary market in bonds. People are buying and selling bonds in the middle of their terms.
So, you could actually find someone to pay you $200,000 for a bond that is, on paper, only worth a principal bond investment amount of $100,000 on maturity.
This is a way to make a capital gain from bond investing – buy when interest rates are high, and sell when they are lower.
Of course, if you try bond investing in the secondary market, you will usually be buying bonds for more than their face value, because people tend not to sell them otherwise. As soon as you have paid more than the original bond investment amount for a bond, you are carrying a risk of capital loss.
Just as the capital value of a bond goes up when interest rates fall, the capital value of a bond falls when interest rates go up. If interest rates move the wrong way, you can lose money if you are bond investing by trading bonds.
On the other hand, if you follow the traditional low-risk model of bond investing, you will buy a bond when it is issued, and hold it until maturity.
In that case, the only risk you have is the risk that the organization which issued the bond gets into financial trouble and cant pay the money back. That is a normal risk of bond investing, and you can judge that risk by looking at the rating of the bond. Bonds rated A are investment-grade bonds, suitable for a conservative bond investing strategy.
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