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## How to Evaluate Bond Issues and Interest Rates

When simplified, investment markets can be divided into two types: equity and debt. Equity investments are the purchase of shares in a company and represent part of the ownership of the business. Stockholders may or may not receive annual dividends. Debt investments, on the other hand, represent a loan to the company with an associated return and expected interest. The bondholder has regular interest payments. Debt investments are considered somewhat safer than stocks, but there is risk associated with any investment.

Debt investments are commonly known as bonds. Bonds can be issued by federal, state and local governments as well as by corporations. Both have advantages and disadvantages. For example, if you invest in a federal bond issue, the interest income you receive on this investment is generally not taxed at the state and local levels. As such, state and local contract interest income is generally not taxed at the federal level. Corporate interest income is taxed everywhere.

It is a good idea to get an interest rate education before you invest in debt instruments. In the United States, the Federal Reserve Bank (or, the “Fed”) sets interest rates. They do this in a meeting held every six to eight weeks where the national economy is evaluated. Then they decide what to do with interest rates. This decision is based on many factors, but primarily the rate of inflation that is experienced.

If inflation rises, the Fed may raise interest rates. This makes the supply of money (in the form of loans) a little tighter and harder, which, in turn, slows down inflation. If there is no or very little inflation, interest rates may stay the same. If there is deflation, or a slow economy, the Fed may try to stimulate it by lowering interest rates, allowing more people to borrow, therefore stimulating the economy.

The reason you need to know what’s happening with interest rates before you invest in bond issues is because bond prices are directly related to current interest rates. In general, if interest rates increase, bond prices decrease and vice versa. Of course, if you intend to keep the relationship until maturity, this does not mean. This only matters if you, like most bond investors, tend to hold it for a shorter period of time, selling before maturity. So if you sell a loan before maturity during a period of rising interest rates, the value of the bond may be lower than what you bought it for.

The main features of the bond issue that you need to know are:

Coupon Rate – This is the interest rate that will be paid to you on this loan. You should also know when it is due. Usually this is once or twice a year on certain days.

Due Date – This is the date the loan becomes due and payable. On this date the company will return the principal you loaned them.

Call Provisions – Some clauses come with the borrower’s right to repay the loan proceeds early. Some are uncalled for. Those that are called are usually paid at a higher price than you originally paid when the initial option is exercised. Note that when a bond issue is in demand and interest rates fall, the company often finds it financially advisable to buy the bond with the proceeds from a new bond issue at the new low rates.

The biggest risk in bond investing is that the issuer goes out of business. This is why federal bonds are so popular; there is literally no chance the federal government will go out of business! Federal treasury bonds are among the safest investments you can make. However, corporate bonds are a different story. Any company can go out of business for any number of reasons. If you have an investment in a company’s bonds when this happens, your investment is worthless almost immediately. DO bondholders have priority over corporations, however, and will get paid first. Senior debt holders can also claim physical assets after the liquidation of the company.

As long as you factor in these risk factors, bonds are a pretty safe investment. A good mix of corporate, federal and local government connections is recommended. Even dumping some junk bonds with high interest rates can be beneficial. Diversification reduces risk, even in the bond market.

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