EARNINGS ON BOND INVESTMENTS

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.

The coupon 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.

Par 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 investments?