Bond Investing Guide 2: How to make money with Bonds
October 23, 2009
This is the continuation of our series on How to Invest in Bonds.
In Bond Investing Guide 1: What are Bonds? you learned what bonds are, how they differ from stocks, and some jargons associated with bond investing.
Here in Part 2, you will learn how to earn from bonds.
There are two ways to make money from bonds: through coupon interest and bond trading. In this article, we will only focus on the first method — coupon interest — and we will defer the discussion of the second method in a later article.
What is Coupon Interest Payment?
The coupon rate is the interest rate the bond pays. This rate is usually fixed for the duration of the life of the bond, although some bonds pay a floating rate, meaning the interest rate is adjusted based on a benchmark rate.
The rate is always quoted in percent, and the interest payment is simply the coupon rate multiplied by the par value of the bond.
How to compute the Interest Payment
Let’s use as example a bond paying a coupon rate of 8% annually with a par value of P100,000.
The interest payment can be computed by multiplying the coupon rate of 8% with the P100,000 par value of the bond.
8% x P100,000 = P8,000
Since the bond pays annually, it will pay bondholders P8,000 interest every year until the maturity date.
Annual- vs. Semiannual- vs. Quarterly-Paying Bond
If, for example, the same bond pays semiannually rather than annually, it will pay interest twice every year (every 6 months). The annual interest payment of P8,000 will simply be divided into two payments, which means the bond investor will get P4,000 every 6 months.
On the other hand, if the bond pays quarterly, the P8,000 annual interest will be divided into four interest payments (to be paid every 3 months). Thus, an investor will receive four payments of P2,000 payable every 3 months.
Pros and Cons of receiving Interest early
In all of those scenarios, the investor will receive a total of P8,000 interest at the end of every year. In the case of semiannual- or quarterly-paying bond, however, the investor receives part of the interest earlier compared to a bond that pays annually. The investor thus benefits from the time value of money because he or she already gets hold of the money rather than waiting for the end of the year to receive the cash.
The risk, on the other hand, is that if the investor wants to reinvest the coupon payment received but interest rates have fallen, the funds can only be reinvested at a lower rate as opposed to the higher rate offered by the original bond. This risk of reinvesting these funds at a lower rate is called reinvestment risk.
Reinvestment risk and other risks associated with bond investing will be discussed in Part 3 of our series on How to Invest in Bonds.
Next: Risks in Bond Investing
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