What are the benefits of bonds for average consumers? how exactly does the premature sale of bonds work? Why do bonds increase in value when the interest rates drop and decrease when the market interest rates are higher?

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Posted by Aiury Cavallo (MONEY FORUMS: 5, Answers: 0)
Asked on November 16, 2015 1:47 pm
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Hi Aiury, great set of questions. Beth provided some great information, I am just going to expand upon it a little bit.

A main reason for investors to purchase bonds is diversification, which lowers total risk. Bonds are not perfectly correlated with stocks; they perform somewhat differently at different times. So your stocks may go up more or your bonds may go up more in a given period. Then to rebalance your portfolio you would sell some of what is relatively higher and invest in what is relatively lower. Using a balanced portfolio approach, where you rebalance to targets of different asset classes removes a lot of emotion from investing. This disciplined approach has been shown to reduce volatility (risk) over periods of time.

I can also give a slight oversimplification of the interest rate sensitivity of bonds. For example, say you purchase a $10,000 bond with an interest rate of 5%. The bond pays you $500 per year, and at maturity you get the face value ($10,000) back. If interest rates drop to 4% other investors can either purchase a $10,000 bond which will pay them $400 per year or influence you to sell yours which pays $500 per year. You will want more than $10,000 to sell it. The drop in interest rates increased the value of the bond. Conversely, consider that you bought a $10,000 bond at 4% and the bond pays you $400 per year. If interest rates increase to 5%, now other investors can purchase a bond which will pay them $500 per year. If you want to sell yours no one will give you $10,000 for it - they can get a better deal elsewhere! So the increase in interest rates decreases the value of your bond. The oversimplification is that you would calculate the stream of income from the bond as discounted cash flow, and also have to consider the quality of the bond, time to maturity, and other factors. But I think the example helps illustrate the effect of changes in interest rates on bond values. Of course, if you hold your bond to maturity then it is worth its face value.
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Posted by Peter Neeves (MONEY FORUMS: 1, Answers: 59)
Answered: November 19, 2015 8:53 pm
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I would have to research the figures, but I don't think the average person invests directly in bonds. They are more likely to be investing in a mutual fund comprised of bonds, likely as part of their retirement savings plan, except maybe for US government savings. bonds. One would invest in a bond because it is generally less risky than buying stock. If the bond pays interest, it also provides an income stream. If you don't want to hold it until it matures to get the face value, you can sell it. This is where the prevailing interest rate when you try to sell it will influence the price you will receive for it. If it pays, say 4% interest, but interest rates are now 5%, you will get less than the face value for the bond. Interest rates and bond prices are inversely related. The person that buys the bond from you will require a higher return, and by paying you less than the face value, they will get that higher return. This is the result of discounting the cash flows at 5% instead of 4%. Discounting involves dividing, so when you divide the same cash flows by a higher number the value goes down.
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Posted by Beth Tallman (MONEY FORUMS: 1, Answers: 61)
Answered: November 17, 2015 5:40 pm