Before we continue our bond discussion, I’d like to recognize a few of our Financial Zen Members.
David, Kevin, Rachel & Dad, thank you for your service. You guys are a million times braver than I’ll ever
be and we owe you and all vets a huge debt of gratitude.
Let’s say today David buys a $1,000 US Treasury bond that matures in 10 years and pays 1% interest per
year.
That means he’ll collect $100 in interest over 10 years.
On Veterans Day NEXT YEAR interest rates have risen and now a 10 year US Treasury bond pays 2%
interest.
So David decides to sell his bond to Kevin to reinvest it in a new US Treasury bond paying the higher 2%
interest rate.
But Kevin won’t pay David $1000 for his bond. Kevin would want to pay less.
He tells David that he’ll buy his bond for $890 and no more.
His reasoning – smartly so – is that if he buys a new bond he’d get $200 in interest, but David’s bond only
has $90 of interest left to pay out.
Since Kevin would miss out on $110 in interest buying David’s bond, he would want a $110 discount off
the price.
That way when the bond matures in 9 years and he receives the $1,000 maturity value, then he’d make
back the $110.
Whether Kevin buys a new bond or buys the bond from David, he expects to collect his 2% in interest.
He doesn’t really care if he gets it from buying a new bond or buying an old one at a discount.
And now you know how the bond market works. (And you are also now smarter than 90% of the investing
public.)
Tomorrow we’ll wrap it up with how bond ETF’s work and why you shouldn’t use them to create passive
income.
