EARNINGS ON BOND INVESTMENTS
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Bond earnings are different from stock earnings, though they both
have potential capital gains. Where stocks' earnings are highly variable, bonds
generally provide a fixed return in the form of coupon payments.
rate is the rate of interest that the individual bond pays to its owner.
A bond's price on the secondary market will fluctuate depending
on the market interest rate. When a bond's coupon rate is equal to the market
interest rate, the bond will sell at its stated, or par, value.
value is the amount stated on the bond, but not necessarily the
purchase price of the bond.
When interest rates go up, the bond will drop in value and sell
at a discount from par value. Just the opposite occurs when rates go down and
the bond then sells for a premium over par value.
Let's take, for example, a 30-year bond with a 7 percent annual
coupon rate and a $1,000 par value. Every year the bondholder will receive a
coupon payment of $70. Although the 7 percent coupon rate will not change for
the duration of the 30 years, the market interest rate will change. If the
market interest rate rises above 7 percent, the market price of the bond will
fall. If the market interest rate falls below 7 percent, the price of the bond
will rise. The combination of coupon payments and capital gains is your total
earnings on bond investments.
Suppose you purchase our 30-year bond for its par value of
$1,000. At the end of the year, you collect the $70 coupon payment and sell the
bond for $1,030. Your return for the year would be 10 percent.
Zero coupon bonds do not make coupon payments. Instead, they are
sold at a discount and redeemed at par value; the bondholder receives accrued
interest gains when the bonds are redeemed. Any amount you receive by selling the bonds over the purchase price and accrued interest may be treated as capital gains.
Of course, the government will want a piece of your
investment earnings. What are the implications of the tax code for your