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Financial Planning for Scientists, Part 8: An Introduction to the Bond Market

In the last few months, we've discussed how to save, and we've looked at one way of investing your money-- the stock market. We discussed the basics of how the stock market works, and how to pick a winning stock. We also looked at some other sites on the Internet that can help you understand the stock market better, and help you pick stocks on an ongoing basis.

But the stock market is just one way of investing your money. This week, we look at a different investment vehicle: the bond.

The bond market is just as complicated as the stock market, but if you understand one, you'll understand the other. At it's most basic, they're identical. The bond market is a public market, and anyone with the desire and the money can buy or sell a bond on that market. And just like the stock market, prices on the bond market are set by the people who are trading the bonds. Another similarity between the two is that when you buy a company's bond, just like when you're buying their stock, you're (usually) buying it from another investor, and not directly from the company.

The big difference is that, when you buy a bond, you're not buying ownership in a company. Instead, you're loaning that company (or government) your money, at a set interest rate. When the bond is first issued (by the company or government), it is set up a lot like any other loan. It pays the lender a fixed amount of interest over a set period. At the end of that period, the principal is paid back to the lender. The "bond market" is the trading, by investors, of these bonds.

So if bonds are traded the same way stocks are, and they're for the same companies that you can buy stocks for, why buy bonds? The nice thing about bonds is that, as a bondholder, you're a lender to the company instead of an owner of the company. In the case of a bankruptcy, that is a big advantage. Lenders get paid back before owners, and that means that your investment is a bit safer than a stock investment.

Also, there's a bit more certainty that you'll get back something in the end. The bond has an expiration date, at which time the company (or government) is obliged to pay you a set sum back. Sure, you don't share in the success of the company in the same way an owner of the company would, but you also don't share their pain if they fail.

All bonds have a few things in common. First, all bonds have a maturity date. That's the date where investors in that bond will be paid back their principal amount. Bonds also have a "bid" and "ask" price (just like stocks). The bid price is the price at which the market is willing to buy the bond; the ask price is the price at which the market is willing to sell the bond. Finally, bonds have what's called a "coupon rate," which is the interest rate that is paid out on the bond.

The confusing thing about bonds is that they have two prices. The first is the bid/ask price, which is the amount the bond is trading for on the open market (give or take someone's commission for selling you the bond). The second is the value that is printed on the bond. For example, a bond with a value of $100 and a coupon rate of 20% might have a bid price that's $110 or $115. What you're buying is $100, invested at 20%, until the maturity date. If the maturity date is a year from now, and what you'd normally get for that $100 in the bank was about 5%, you'd be willing to pay a premium to get the 20%. You'd have to calculate how much $120 in one year was worth right now, at 5% interest.

Luckily, when the prices of bonds are printed in the paper, or on the Internet, someone's already calculated that for you. The last column in a bond listing is the "yield" column. The yield is the calculated real interest rate of the bond, if it is bought at today's bid price and kept until maturity. This way, you can compare bonds, even though they have different bid prices and different coupon rates.

Well, now you know how to read a bond chart. Picking your bond will depend on the yield, the maturity date, and, of course, the company or government you're lending your money to. This last factor is a very important one--a risky company will need to pay a higher interest rate to attract lenders. Luckily, experts in the bond market evaluate the "riskiness" of the bond, and rate that riskiness on a standardized scale.

Next month, we'll take a closer look at the bond market. We'll learn about this standardized scale, and we'll learn about "securitized bonds," a special form of bond where the loan is guaranteed by specific assets of the company. We'll also talk about the tax implications of buying bonds instead of stock. But if this discussion is getting too complex for you already, don't worry. Two articles from now we'll learn about bond funds and mutual funds--two ways of getting someone else to figure out all these details for you.