How to invest and make money with Bonds
In the first article in our Bond Investment Guide series “What are Bonds?” you’ve learned what bonds are, how they differ from stocks, and some jargons associated with bond investing.
Here in Part 2, you will learn how you can make money from bonds.
There are two ways to earn in bond investing:
- Through coupon interest payments; and
- Bond trading
In this article, we will focus on the first method: coupon interest payments.
What is Coupon Interest Payment?
Simply speaking, the coupon rate is the interest rate that the bond pays. This translates to the income the holder of the bond will be receiving.
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 Coupon Interest Payment
To make it easier to understand, 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, the issuer will pay bondholders P8,000 interest every year until the maturity date.
Date of Coupon Interest Payments
As mentioned earlier, some bonds have varying dates of payments. Some pay annually (once a year), some pay semi-annually (every 6 months), while some pay quarterly (every 3 months).
If, for example, the bond in our example above pays semiannually rather than annually, it will pay interest twice every year, that is, every 6 months.
The annual interest payment of P8,000 will then 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, for a total of P8,000 interest income still for the year.
Which Interest Payment Period is Better?
In all scenarios above, 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 benefits from the time value of money because he or she already gets hold of the money rather than wait 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”.
(Read Part 3 in our Bond Investing Guide: Risks in Bond Investing)
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