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I'm considering looking into buying bonds, and it seems there are two approaches one can take:

  1. Buying the bond and holding it until maturity. Here you get the interest (coupon) as agreed upon when it is bought.
  2. Buying the bond and trading it before maturity. This could be at a loss or gain, depending on the market for the bond at the time you sell.

What would influence someone to take one or the other path? Without knowing much I am drawn to the first strategy, because I want to reduce complexity and not need to worry about timing the selling well. So, if I buy a bond at x% interest, I will know I am getting x% interest over the life of the bond (as long as the issuer doesn't default, of course). It becomes more like a CD, a "set it and forget it" approach.

But...the common wish to reduce complexity often, in my experience, comes at a high cost of profit, and I know, despite inherent laziness, I ought to sweat the details rather than miss the profit. So then, what are the real pros and cons of these two approaches?

(Please correct anything I've mis-stated above, as, again, most of this is mysterious to me still).

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Usually it doesn't make sense for an individual investor to buy and hold a tradeable bond, because you can obtain similar rates through risk-free investments like US Savings Bonds, CDs and deposit accounts.

Holding a bond generally means that:

  • You have to commit $10,000 of principal
  • You are subject to default risk (ie. you don't get paid)
  • You are subject to interest rate risk (ie. rising rates reduce the value of your bond).

To be able to hold a bond to maturity, you need to have the discipline to hold on, even if the value shifts dramatically. In 2012, that means that if our ridiculously low interest rates go away and the rate for a high-quality 30 year bond goes up to 12% in 2017, the value of your 3% bond will nose-dive. Do you have the discipline to stay the course and not panic?

Additionally, most bonds these days are recallable -- so if you had a bond with a high rate of interest, and rates go down, the borrower can just recall the bond.

If you want a simple way to invest in the bond market, find a category of bonds that meets your needs, and buy a mutual fund or ETF. Let the professionals manage a portfolio of bonds.

  • @If the 30 year bond rate goes up to 12% (and therefore you could only sell your old bond for much less than you bought it for), there must be a straightforward calculus as to whether you should sell or hold it. Let's say selling will put $70 in your pocket now. Now you can buy $70 worth of new bonds at 12%. So is $70 at 12% better than $100 at 3%? Yes. So you should sell. Isn't this just a matter of math then? – Chelonian Jan 27 '12 at 18:49
  • @Chelonian not quite, If the rate rises to 12% by 2017, Duff's 3% bond is worth about $2941. And he can buy $2941 in new bonds at 12%. Respectfully, you need a BA-35. (finance calculator) – JoeTaxpayer Jan 27 '12 at 23:25
  • @JoeTaxpayer What are you assuming he bought his bond for if he can now sell it for $2941? Oh and yes, I fully admit I am like a fish on a pier on how to think about this, so keep those corrections coming. :D – Chelonian Jan 28 '12 at 3:15
  • $10000 as he stated. I see, your comment was in term of $100 face. – JoeTaxpayer Jan 28 '12 at 3:25
  • +1 for looking at the broader question of whether someone ought to be buying individual bonds or not. – poolie Jan 28 '12 at 5:18
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I'm going to hazard there are two main categories: tax, and then everything else.

For tax, you may want to avoid getting profits in the form of income rather than capital gains, or you may not care: this will depend a lot on the details of the bond, your country, your broader tax situation. For instance you may want to sell just before a coupon is going to be paid, or you may want to sell to harvest a tax lost.

For non-tax reasons, I think the short answer is that it only makes a difference if you think you can accurately judge when to buy and sell. Some writers (citation needed) suggest that the bond market is more efficient and harder to time than the equity market. The price of a bond is going to go up and down over its lifetime but as it approaches maturity it will converge on the final price.

(I don't feel this is a great answer; please edit.)

  • 1
    You addressed what I did not, the tax concerns. +1 – JoeTaxpayer Jan 27 '12 at 14:33
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You wrote "Buying the bond and trading it before maturity. This could be at a loss or gain, depending on the market for the bond at the time you sell."

This is an example of how the price will change as rates change. Say I bought a bond 10 years ago. A 30 year bond yielding about 5.5%. Now, the 20 year bond is 2.67, and my coupon taken into account, the current value of the bond rises to $143.

It is essential you understand this. As rates drop, the value of the bond rises. And in fact, if the current 20 year rate were 2.67%, a 5.5% coupon bond would have the $143 value I cite.

Edit - The simple way to look at this is that when new bonds have a 2.67% coupon, and the one you own has 5.5%, it makes yours more valuable than $100 face value. 5.5% - 2.67% = 2.83%, so the coupons have 2.83 * 20 or 56.6% extra. But the time value of money diminishes this a bit, and the premium is $43. The actual calculation I did using a financial calculator, the same as I use for mortgage computations.

If you do nothing, you keep collecting the 5.5% coupon, and 20 years hence the face value of $100 is yours.

The "con" as you ask, is that you don't have a higher yield option right now. But if rates shoot up, you took your gain and don't watch the current value drop to $100.

(Note, this is an edited attempt to clarify this answer. I welcome other high rated users to directly edit my explanation.)

Not to appear a total geek, the money spent on a financial calculator is well worth it. I can try to explain the process all day long, but the seeing it in your hand and changing values for each rate or term to find new present values is a handy exercise. The TI BA-35 I link to is the simplest to use, I never read the manual.

  • Unfortunately I don't understand this at all. Let's start with "the current value of the bond reflects 2.67%". What do you mean, "reflects"? I thought the bond returned 5.5%. Can't I just hang onto it for 20 more years and enjoy a 5.5% return? – Chelonian Jan 26 '12 at 23:44
  • Thanks, that I do understand. But could you follow up with the math that produces the $143? – Chelonian Jan 27 '12 at 22:21
  • done, one edit in the middle. – JoeTaxpayer Jan 27 '12 at 22:50

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