When you buy a bond or other fixed income security, you are lending your money to a government or company for a certain period of time. In return, they promise to pay you a fixed rate of interest at certain times and to repay the “face value” at the end of the bond’s term (its maturity date).
The face value is the value the fixed income security was issued at and is the value you receive when it matures. Interest payments are based on the face value. For example, a bond that has a face value of $1,000 and an interest rate of 5% would pay you $50 a year.
Fixed income securities may be bought and sold at a price higher or lower than their face value. The value of a fixed income security will fluctuate as interest rates change. For example, if interest rates go down, the value of a bond would normally go up because its relatively higher fixed interest payments are more attractive to investors. Changes in the credit rating of the issuer can also affect the value.
You can make money if you sell a fixed income security for more than you paid for it (capital gain) or lose money if you sell it for less (capital loss). The actual return or “yield” that you earn on a fixed income security depends on the price you pay for it and the time remaining until it matures.
For example, a bond with an interest rate of 5% will pay you $50 a year for each $1,000 in face value. If you buy the bond for $950, your actual rate of return will be higher than 5%. If you buy the bond for $1,050, your actual rate of return will be lower than 5%. Calculating the yield precisely can be complex but a financial adviser can do this for you.
Many fixed income securities come with a guarantee and are relatively safe. They tend to offer better rates of return than cash equivalent investments because you’re taking on more risk by lending out your money for a longer period. Other fixed income securities, like “junk” bonds, offer much higher rates of return, but they can be very risky and have no guarantees.
Most fixed income securities are sold through investment dealers.
This has been the fourth post in our Investments at a Glance summer series. Next week, we look at specific types of fixed income securities, bonds and debentures.
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