How To Make Money From Bonds

I hope the weekend treated you well. Last week the Republican National Convention, and this week the Democrats will have their turn. I know, lots of chatter indeed.

In my political conversations with family and friends, we often talk about whether or not we’ll be any happier with a new President in office. Trust me, you don’t want to read our family emails – they are fierce!

Well, a similar line of question is raised when we think about our money. I read a NYTimes piece that scratched the surface on the linkage between money and happiness. My favorite part…

In fact, academics have a name for this [pursuit of happiness] cycle , which involves fixating on what we don’t have, actually getting that thing, not ending up any happier and then fixating on something else. They call it the hedonic treadmill. Despite all our efforts, we never get anywhere. We experience small ups and downs, but by and large, our happiness stays the same.

It’s important to keep this in mind because money is emotional and while we all need to stay focused (which we talked about last week) on our money goals, remember that you also must keep in mind why you are doing your money thing.

With that, I promised you I would share with you how to make money from bonds in case that will make you happier. Here you go.

How Do You Make Money From Bonds?

When you buy a bond, you are lending a company (like Nike) money and the company is promising to pay you back what you loaned them PLUS interest. The interest payment is typically determined from the coupon rate. So, if I bought a $100 bond with a 5% annual coupon over 3 years, at the end of the 3 years, I would get the $100 back. And, I would have received $5 at the end of the each of the three years, or $15. This assumes that I hold the bond for all 3 years.

Many people use bond investing as an income generating strategy because the company (otherwise known as the borrower) is contractually obligated to pay you back that original amount plus interest. Because of that, investing in bonds is less risky than investing in stocks, where you could lose all your money.

So, what's all this talk about bond yields and interest rates? And, how is that different than a coupon rate? In short, all of these terms are technically different but related. I won’t bore you or complicate things with the math, but all you need to understand is that interest rates directly affect bond yields in the same direction; low interest rates means low bond yields, and effectively a lower return on your money.

When bond yields are low, the price of the bond (like the $100 I mentioned above) will go up  – this is a fundamental relationship that is all you need to know.  Forget why this happens for now. What’s important for you is that the coupon rate never changes, but because the price of the bond is higher, if you sell it, you effectively earn less money ($5 over $105, or 4.6%, is lower than $5 over $100, or 5%).

Investors make investing decisions based on a bond’s yield (rather than coupon) because it effectively tells you what you can expect to receive in return more so than the coupon rate.

What's next?

Tell me how you really feel. Leave a comment below!

I want to hear from you!