👋 Good afternoon finance enthusiasts and fellow investors!
Are you ready to take your investment knowledge to the next level? Today, I want to talk to you about one of the most fundamental aspects of investing - bonds.
Compared to crypto, bonds are probably the most boring stuff out there 🥱... but the recent crypto price increases are all related to bonds! Why? Bonds play an important role in the current banking crisis that many banks are facing. And since the banks are doing poorly, the topic of cryptocurrencies is naturally becoming more and more interesting to people 📈
Let's find out more together.
💎 TL;DR
A bond is a debt security that represents a loan made by an investor to a bond issuer.
A bond yields a return and is considered a lower-risk investment.
When interest rates rise, the value of existing bonds decreases, because new bonds are issued at a higher rate, making the existing bonds less attractive.
This is one of the reasons for the current crisis many banks are facing.
The information provided in this newsletter is for educational and informational purposes only and should not be considered as financial advice.
🧠 What is a bond?
A bond is essentially a loan that you give to a company or government. They promise to pay you back the money with interest at a set date in the future.
Interest payments are made at regular intervals, for example annually.
At the end, the bond is paid back to the investor in full.
Bonds are a type of security and are a regulated financial instrument.
There are also other types of bonds, but most bonds work like this.
Words you need to know
Coupon: The interest payment that the bond pays to the investor.
Face value: The amount of money the bond is worth at maturity and which will be repaid to the investor.
Maturity: The period of time until the face value is repaid to the investor.
Bond rating: The bond issuer's credit rating from AAA (high credit quality) to C (low credit quality).
💰 How are bonds priced?
The price of a bond is based on its face value, which is the amount that it will pay out when it matures, and the interest rate that it pays.
Between interest payments, the value of the bond increases as the interest payment date approaches.
In addition, the basic principle of supply and demand applies on the free market. This also affects the price, as you will see in the next chapter.
⚖️ How do interest rates affect bonds?
When interest rates rise, the value of existing bonds decreases, because new bonds are issued at a higher rate, making the existing bonds less attractive.
When interest rates fall, the value of existing bonds increases, because new bonds are issued at a lower rate, making the alfready existing bonds more attractive.
😬 The current situation in the financial system
Inflation has gone through the roof in recent months, causing a decrease in the purchasing power of money.
Interest rates have gone up in the last months as a result of the Federal Reserve's efforts to combat inflation.
Bond prices have gone down as a result of the increase in interest rates.
As people want their deposits back, banks may have to sell securities to provide liquidity.
In the case of most bonds, they are currently trading below their value, which results in a loss as soon as the bank has to sell the bond to generate liquidity.
This is one of the reasons for the recent bankruptcies of Silicon Valley Bank, Signature Bank, and First Republic Bank.
So, there you have it - a basic breakdown of bonds and their relationship to interest rates in the current financial situation. If you're looking to diversify your investment portfolio, bonds can still be a great option, but make sure to keep an eye on interest rates and the current state of the financial system!
🎯 Take action
Enough of the theoretical explanations. Here are some practical steps you should consider before investing in a bond.
Determine your investment goals and risk tolerance. Make sure you understand what you're trying to achieve by investing in bonds and how much risk you're willing to take on.
Research bond issuers and ratings. Look into the financial health of potential issuers and understand bond ratings to make sure you're comfortable with the creditworthiness of the borrower.
Consider bond yields and types. Understand the annual return you'll receive and compare yields across different types of bonds to make an informed decision.
Decide on the appropriate maturity for your investment goals and risk tolerance.
Purchase the bond through a broker or an online platform. Make sure you understand the fees associated with the purchase and the settlement date.
Remember, investing is a long-term game, and the more knowledge you have, the better prepared you'll be to make informed decisions.
That’s it for today. Enjoy your weekend!
Cheers
Stefan
PS: As always, let me know in case you have questions or need help.
But the rating from AAA to C is only the Moody's rating, am I right?