Sunday, January 6, 2013

2013 Outlook Part 2: What Is A Bond?

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

Imagine that Ted wants to raise some money to start a home business. He goes over to his friend Jim’s house for a few beers and he tells him about his idea. The only problem Ted tells Jim, is that he is a little short of start up capital.

"No problem," says Jim. "I will lend you $10,000 at 10% interest per year for a period of 10 years." That means that Ted owes Jim $1,000 per year over those ten years and then he must pay back the entire $10,000 (principal).  

This is a called a bond.

It is the prime tool that banks, corporations, local governments and national governments use to raise money.  Another option to raise money for corporations would be the sale of stock (going public), but we’ll discuss stocks in a later section.

While the interest rate on a bond is fixed when you buy it, the underlying principal (the amount of debt you purchased) has the ability to change in value in the open market – just as a stock has the ability to change in value. Many average hard working people, most of which are loading their retirement accounts with bonds as I type this, have no idea how bond prices work.

We’re going to come back to this story with Jim and Ted in just a moment to see how it ends, but first let’s take a brief look at how we arrived at this point in the bond market cycle.

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