In The New Investor's Guide to Investing in Bonds, you learned most of the basics of bonds. For those who want the short answer to the question, "How do I start making money from investing in bonds?", I wrote this introduction. It is designed to help you understand the two primary ways of making money in fixed income investments (another word for bonds because the bond coupon you receive is the same, or "fixed"), serving as a useful starting point to your education.
Bond Investors Make Money from Interest Income and from Capital Gains
There are two primary ways for bond investors to make money. They are:
- Making Money from Interest Income: When you buy a bond, you are loaning money to the issuer. Sometimes, the bond issuer is a corporation (corporate bonds), other times a government or municipality (sovereign or municipal bonds). The interest rate, or the coupon rate, is determined by the general level of interest rates at the time, the maturity of the bond, and the credit rating of the issuer. If you buy a $1,000,000 bond from Coca-Cola when it is issued, and the coupon rate is 7%, you should collect $70,000 per year in interest income. If the maturity is 30 years in the future, you will receive your original $1,000,000 investment back 30 years from the date the bond is issued. This could be a great deal for you, because you get money to live on and pay your bills, and a great deal for Coke, because they can use the money to build new facilities, expand their product line, buy bottlers, or meet other needs.
- Making Money from Capital Gains: Many bonds are not held until maturity. Investors need money back before their bonds mature so they sell them through a broker. When that happens, you might earn a capital gain or experience a capital loss depending upon what has happened to the credit quality of the issuer (e.g., if the company that sold you your bond has gone from being incredibly healthy to on the verge of a bankruptcy filing, you are only going to get pennies on the dollar because other bond investors aren't going to be willing to take the chance unless they are paid a high rate of return). Likewise, if interest rates have increased, your bond will have lost value because investors will demand you give them a higher return than the coupon rate. That is, if you buy your Coke bond yielding 7% and suddenly comparable bonds are yielding 10%, you are going to have to lower your price until your bond is yielding 10%, too. Otherwise, why would anyone buy it when they could just buy a newly issued bond for a higher yield? On the other hand, if bond rates fell, you could sell your bond for a higher price, earning a capital gains profit. To understand the relationship between making money in bonds and interest rates, read about a concept known as bond duration.