There are two primary ways for bond investors to make money: collecting interest income and generating capital gains. It's important to understand these concepts—as well as the other basics of investing in bonds—if you're interested in pursuing fixed income securities.
Collecting Interest Income
When you buy a bond, you're loaning money to the issuer. Sometimes, the bond issuer is a corporation (corporate bonds), and other times it's a government or municipality (sovereign or municipal bonds).
The interest rate, or the coupon rate, is determined by the general level of interest rates at the time, the maturity of the bond, and the credit rating of the issuer. For example, if you buy a $1,000 bond from a company when they are issued, and the coupon rate is 7%, you should collect $70 per year in interest income.
If the maturity is 30 years in the future, you will receive your original $1,000 investment back 30 years from the date the bond is issued. This could be a great deal for you because you receive extra money, and a great deal for the company, because they can use the money to build new facilities, expand their product lines, or meet other needs.
To understand the relationship between making money in bonds and interest rates, read about a concept known as bond duration.
Generating Capital Gains
Many bonds are not held until maturity. If you need money back before your bonds mature, then you have the option of selling them through a broker. When that happens, you might earn a capital gain or experience a capital loss depending upon what has happened to the credit quality of the issuer and direction of interest rates.
If the company that sold you your bond has gone from being incredibly healthy to on the verge of a bankruptcy filing, then you're only going to get pennies on the dollar because other bond investors aren't going to be willing to take the chance unless they are paid a high rate of return. Likewise, if interest rates have increased, your bond will have lost value because investors will demand you give them a higher return than the coupon rate.
For example, if you buy a corporate bond yielding 7%, and suddenly, comparable bonds are yielding 10%, you're going to have to lower your price until your bond is yielding 10%, too. Investors aren't likely to buy it if they could just buy a newly issued bond for a higher yield.
On the other hand, if bond rates fall, you could sell your bond for a higher price to earn a capital gains profit.
More Resources for Investing in Bonds
Before investing in bonds, it's important to become informed on some of the basics. Here's a list of resources that can help you do just that: