How do you make money out of Bonds?

Apart form the obvious answer- sit back and collect the interest, this is the driving force behind the so-called bond market.

Interest rates are dynamic things, depending not only on the term of the bond and credit rating of the bond organizer but timing as well- global and local market forces which affect the overall interest rate climate in general.

Now lets look at a simple example. Let's say you take out $10000 worth of a thirty-year bond paying a coupon rate of 5%. That means $500 interest income to you per year. One year into the bond you decide you need the capital back. But there is a recession on and overall interest rates on similar thirty years bonds are now 4%. Quite coincidentally, the same one-year on, your neighbour is looking at putting $12500 worth of his money into a thirty-year bond. He is budgeting to receive 4% interest, which equates to $500 per year. Just as he is about to put on his akabura hat and drive into the big city to do the deal, you shout at him over the back fence, to come over for a beer.

You confront him with your offer.

"Why stuff yourself into a starched shirt, and drive 400km to draw up this contract with your banker?" you say.

"I have this bond which I want to sell. You hand over the $12500 to me and I will sign this bond over to you, and you still get your $500 per year."

The neighbour thinks for a moment and takes off his hat. "Deal" he says.

You are happy because you have got your capital out, and your neighbour is happy because he has locked in the $500 per year income stream that he wanted.

But something has changed. You started out with $10000 capital and one year on you now have $12500. You have made a capital gain of $2500. But this whole scenario depends on prevailing interest rates going down from 5% to 4%. Reverse the interest rate direction and by the same logic you can see how it is possible to make a capital loss.

The other thing to notice is that your neighbour invested in your bond, which yielded him 4% interest. But when you took out the bond it was at a coupon rate of 5%. Did your neighbour care? No, because he was getting the market rate of 4%. So we can see that any bond has both a coupon rate and a market rate and these are not usually the same.

Like shares, bonds have a futures market and can be sold long or sold short. But since this sort of derivative trading has already been covered in the stocks and shares section of this FAQ I mention it only in passing here.