Understanding Bond Prices

many investors own bonds in their portfolios. But few understand how bonds work. While I don't expect you to have a thorough knowledge of the bond market, a basic understanding of bonds is beneficial.

For example, did you know that a bond's price and yield are determined by a few key factors? Allow me to review them with you.

Interest Rates

Interest rates are inversely related to a bond's price. Understanding this relationship helps you determine the value of a bond. Just remember, when interest rates go down, bond prices go up and vice versa.

Liquidity

Since small bond issues are not as actively traded as large issues, bondholders are compensated by higher yields. If liquidity is not a concern, you could benefit from buying a small issue.

Term To Maturity

Given the uncertainty of future interest rates, long-term bondholders are generally better compensated than short-term bondholders. So if you're investing for income, stick to long-term bonds. Just be sure you won't need the money soon - prices will fluctuate with interest rates, and the further out the maturity date, the more it will fluctuate.

Issuer's Credit Rating

The higher your bond's rating, the safer it is, and the lower its yield. The best rating is "AAA"The worst is "D." If peace of mind is important to you, look for a "BBB" rating or higher - that's the line between investment grade and speculative (or "junk") bonds.

Unique Features

Many bonds have unique features (i.e., callable bonds, or extendable bonds). It's important to understand how these features can impact your future income.