Your Questions About Stocks And Bonds For Beginners

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Richard asks…

Help! I want to invest in something but I don’t know anything about it!?

My dad told me the best place to start would be a risk free investment like a government bond. How does it work? Who do I buy the bonds from? Also, what are some other risk free or minimal risk investments for beginners? I’m 17 btw and I was never taught anything about how money or stocks work at school 🙁

financi4 answers:

Government bonds are not totally risk free. Yes you will get your investment back at maturity normally and paid an annual interest rate while you hold the bond but the bond price will fluctuate daily depending on the current interest rate.

If you purchase short term government bonds (3 months to 5 years), the interest rate will probably not be any better than rates that you can get by purchasing a government insured certificate of deposit (CD) of the same time length but if you sell it on the open market before it matures, you may not get back what you paid for it. If you purchase a CD and cash it in before the maturity, you will always get the same price back that you paid for it but you may lose 3-6 months interest.

The only way to get a half decent interest rate on government bonds is to purchase longer term 10 or 30 year government bonds. Currently 10 year government bonds pay about 2.60% annual interest and 30 year pay about 3.66%. These interest rates are low because interest rates have been dropping over the past couple of years.

The risk with holding long term government bonds is that if interest rates rise and you want to sell the bond before maturity, you may get significantly less than you paid for the bond. The reason for this is that interest rates move up or down so therefore when you want to sell your bond, investors will pay a price for your bond that is based on the current interest rate.

The following is an extreme example and has been simplified:

You purchase a 10 year treasury bond that has a face value of $100 for $100 that is paying 3%.

Three years from now the government is selling 10 year treasury bonds that are paying 7%.

At that time, you decide that you need the money and decide to sell your bond which has 7 years remaining to maturity.

Why would any investor pay you $100 for your bond that pays 3% when they could purchase a bond from the government that pays 7%? They won’t.

So therefore there is a complicated formula that is used to determine what your bond should sell for. First it takes into consideration that your bond is no longer a 10 year bond but in reality is a 7 year bond. The expected interest rate for a 7 year bond my be 6% instead of 7% so your bond would be paying 3% less annually than what was expected. To produce the same yield, your bond would need to sell for a discount of 50% but there is more than just yield in that the purchaser would also get a capital gain of $50 at maturity if he purchased it for a discount of 50%. So this complicated formula may determine that a discount of 20% should be given to the purchaser which will give him a yield of 3.75% per year and a capital gain of $20 at maturity.

The opposite has been happening over the past 6 months where interest rates have been dropping so therefore anyone who purchased treasury bonds 6 months ago is now holding a bond that has a greater market value than one that is purchased today. See the following chart that will show that 30 year treasury bonds have gone from a yield of about 5% six months ago to a current yield of 3.66% today.

Http://finance.yahoo.com/q/bc?s=%5ETYX&t=6m&l=on&z=m&q=l&c=

Therefore as long as interest rates drop you make more than the yield (you also make capital gains if you sell the bond before maturity) but if interest rates rise, you will either be stuck with a lower than market interest rate or you will have a capital loss if you sell the bond before maturity.

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