Bonds

Bonds are a means by which investors lend money to companies and governments, which becomes paid back at a future date and earns a certain amount of interest. Bonds can be a great way to earn a revenue stream on money invested. They are generally more stable and less risky than stocks, and suitable for those looking to add a more conservative component to their portfolios.

Understanding Bonds

Learn why bonds are such an important component of many people’s investment portfolios and why they can provide balance as well as fairly reliable income to investors.

Bonds Involve Lending Money

When a business is looking to borrow money, they can either borrow it from a financial institution, or they can issue bonds. Governments of every level also borrow money by issuing bonds.

BondsSo this is what bonds are, lending money to either companies or governments, where one would receive a yield on the money loaned, generally but not always by way of receiving interest payments. The loan is eventually paid off, provided that the bond issuer does not default, and there’s always a risk of that, even though it may be extremely small.

The yield that bonds pay out, what you receive back in profit, tends to be in line with the perceived risk that is involved in holding a bond. To look to minimize the guesswork and speculation here, the credit risk of bonds are rated by bond rating companies, such as Standard and Poor’s, and Moody’s, who are the two largest and the ones that the bond market pays attention to the most.

So when you hear or read that a company’s or a government’s bond rating has changed, this is a big deal indeed, as this affects what they will have to pay out to borrow money by way of issuing bonds.

So bonds are a form of credit, a debt obligation to the bearer of the bond, so when you invest in bonds you are performing the same role banks do, and the idea is to make income from the debt that you are buying.

What’s Involved in Investing in Bonds

Bondholders are first in line should a company or government become insolvent, and it’s only after the bondholders have been fully paid that shareholders get to divide the remainder, with preferred shareholders getting fully paid before common shareholders receive any funds. Often there is little to nothing left by the time common shareholders get to make their claims.

These are owners of the company so to speak, so in addition to the business profits by way of dividends they receive, they also have to bear the risks involved in the business, whereas bondholders are owed money by the business, so the debts get paid first, as with any insolvency proceeding.

Bonds also involve market risk as well, as bonds are traded in financial markets, and their value does fluctuate, and can fluctuate quite a bit depending on the market circumstances. Bonds are initially bought by large financial institutions, who then sell them to the public on the secondary market, as is the case with all securities offerings.

Since bonds are priced based upon interest rates in general, as they essentially pay interest to bond bearers, fluctuations in interest rates do affect bond prices quite a bit, and in an inverse manner.

So when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. It’s not hard to understand why. Let’s say that you buy a bond which pays out 4% interest. At the time you bought it, that was a good deal, relative to interest rates at the time.

However, interest rates go down, and now your 4% interest on the bond is an even better deal. People are now willing to pay more for it and you can sell it to them and earn capital appreciation if you wish. When interest rates go up, the bond is worth less and you will take a loss selling it, because the relative value of the interest it pays has diminished.

Bonds don’t generally need to be redeemed or sold through, at least until the bond matures, which can be anywhere from a day to 30 years depending on the term. However, even if you do hold it, if it becomes devalued, you will still lose value in a relative way, as you could be holding something else during this time which would provide a higher yield on your money, or invest in something else altogether that may be more bullish.

So unlike stocks, where one can not worry too much or even at all about fluctuations in price when the intention is to hold it long term, bond investors need to be aware a little more of the changing value of their bonds, although this may be more or less of an issue depending on one’s strategy and time horizon.

The Nuts and Bolts of Bond Investing

There are a lot of different types of bonds with a number of different features, and some bonds don’t even pay interest, zero coupon bonds they are called, yet in all cases there is a yield, a profit involved in lending the money. So in the case of zero coupon bonds the yield is achieved by their being sold at a discount to their redemption value, for instance selling it for $800 with a redemption value of $1000.

Most bonds are interest bearing though, and at one time they used to have coupons on them which would be redeemed for interest payments, and you would tear off a coupon every so often and collect the interest.

This is not required these days as records are kept to ensure that bondholders receive their interest payments at the specified schedule. Unlike loans though, the principal amount of the loan is generally not paid back at regular intervals, and is paid back instead at maturity, although this is not always the case, and some bonds to pay back the principal amount in installments.

Some bonds are callable by the bond issuer, meaning that they can buy them back from you if they exercise this option, but most bonds are not callable. Callable bonds pay out a premium for this because it’s to the advantage of the bond issuer to be able to do this, if interest rates drop enough and it’s in their best interest to not pay out such high relative interest going forward.

Some bonds are also convertible, meaning that they may be converted to stock by bondholders if they so choose, depending on the movement of the price of the stock of the company issuing the bond.

Both of these options, callable and convertible, in addition to some other options that you see with bonds, are only applicable to corporate bonds. There are also bonds that pay back the principal at regular intervals, like loans do, called serial bonds. Most corporate bonds do not have any of these options, and the standard no option payable on maturity bond is called bullet bonds.

Corporate bonds are one of three different types, with municipal bonds, issued by local and state governments, and government bonds, issued by federal governments, being the other two.

In all cases, the issuer is looking to raise money, either for company expansion, a public works project, or to manage government spending overall, including managing government deficits and debt.

Investing in Bonds

Bonds are a less risky and more stable investments than stocks are, as long as the bonds traded are of high quality, and most bonds are. Bonds don’t depend so much on how the company is doing, as long as it’s likely they will stay in business, where stocks move with every up and down of the business.

Bonds do differ though as far as risk goes, with government bonds of the shortest duration, such as treasury bills, and other very short term paper being the least risky and the most stable.

This low yielding paper is generally considered to be what’s called money market investment though, and bond investing generally refers to debt that has a medium to long term maturity, as this is where one can get the kind of yields that investors seek to gain a reasonable amount of income.

Risk and reward is always inversely related in all investments, and bonds provide a nice balance between the two, for those who want a more stable component of their portfolio than stocks and other fairly volatile investments, yet want to earn more than the typical interest rate paid by banks as well as money market funds.

While bonds almost always do pay interest, we speak of the return with bonds as yields, because even though there is an interest payment usually involved, the value of bonds is always a combination of the price you paid relative to the redemption value plus the interest earned, not just the interest.

This actually isn’t that difficult to understand, as for instance if you bought a bond for less than its face value, the profit you realize if you do hold it to maturity would be the difference between what you paid and its maturity value, plus the interest. This can all be expressed as a percentage of your investment, as a return, which is called a yield.

Of course this can go the other way as well, and you may pay a premium for the bond depending on the circumstances, pay more than it’s worth at maturity, and that extra money paid must be deducted from the interest earned to get the actual yield of the investment.

People often do not hold bonds to maturity though, but the yield realized still matters as much, as a function of the annualized percentage of what you made or lost on it works out to. When a bond is sold prior to redemption, you always need to calculate the difference in the price paid relative to the price received to calculate what yield you ended up with.

Individual investors generally don’t ever trade the bond market directly, as this is usually done by institutional investors, or if an investor has a lot of capital, by someone managing their portfolio. Bond funds, or bonds as a component of a fund, may play a big role in an individual investor’s portfolio, and although investors don’t generally select bonds individually the way they may select stocks for instance, it’s still good to have an idea of what this investment consists of, and the role that it plays in one’s portfolio.

So bonds serve to both provide income and also to balance out portfolios toward less volatility and risk, which often is necessary to some degree to best achieve one’s particular investment strategies.

Bonds FAQs

  • How do I invest in bonds?
    There are two ways to invest in bonds, by buying bonds directly, or by buying shares in a bond fund. Treasuries can be purchased directly from the government, but other bonds must be bought from a broker and require a significant investment. Buying shares in a bond fund makes this much more accessible.
  • How do bonds work?
    Buying bonds involve lending money to the bond issuer, either a government or a company. The issuer gets their money up front and makes interest payments on the debt periodically, and pays the principal back upon maturity. Once issued, these bonds become traded among investors who buy this debt.
  • Can you lose money investing in bonds?
    Although bonds do pay interest, the value of this stream of interest payments changes over time. If you sell bonds at a lower price than you paid for them, this will incur a capital loss, just like selling stocks at a lower price does. If this loss is greater than the interest you earned to date, you can lose money.
  • What are some examples of bonds?
    National governments issue treasury bonds and treasury bills that are issued and then traded among investors. State and local governments also issue bonds to fund their activities. Corporations also raise money by issuing bonds as a means of borrowing to run and expand their businesses.
  • How do beginners invest in bonds?
    Buying treasuries is a fairly simple process, but this does require some real analysis to decide whether treasuries are a good investment at any given point in time. Other bonds also require analysis, and even seasoned investors will seek out advice here. Buying a bond fund is best for beginners.
  • Are bonds safer than stocks?
    You can lose money investing in both stocks and bonds, but you can lose a lot more with stocks because the price of stocks can drop a lot more than bonds and stay lower a lot longer as well. Bonds also pay interest so even when their price declines, this interest can serve to offset capital losses.
  • Are bonds a good investment now?
    We can never look at an investment in isolation or look to approach it generally, as whether it is a good investment or not will depend on a number of factors such as our goals, our risk tolerance, and relative performance among potential investments. A good investment now may also turn out to be a poor one later.
  • What are the best bonds to buy?
    Bonds are priced by risk, where those that are the least risky pay the least amount of interest, and the interest paid goes up as the risk of default increases. It is often wise to go with a diversified portfolio of bonds such as you would find in a bond fund, which seeks the right balance between risk and return.
  • Are bonds guaranteed?
    All bonds come with a risk of default, even though this risk may be so low as to be considered risk-free. Even the U.S. government can go into default though if dire enough events happen. If your bonds default, you can lose some or even all of your investment, and no bond is ever guaranteed.
  • Why do people buy bonds?
    Buying bonds can provide people with a relatively safe investment, and the risk involved is considerably less than with investing in stocks. Buying U.S. treasuries is even less risky than putting your money in a bank. Bonds involve collecting interest payments on debt with a good expectation that your money will be repaid.
  • When should you buy stocks vs bonds?
    We should be buying and holding stocks when stocks are going up in value because stocks go up in value a lot more than bonds do. Sometimes stocks go down in value for an extended period, called a bear market, and bonds can outperform them. If we’re cashing out soon, bonds can be particularly appealing.
  • How much do bonds pay?
    Bonds pay a certain amount of interest per year, called the coupon rate, as they used to have coupons you would tear off to collect interest. This is what we buy when we buy bonds, the rights to collect this interest and also have our investment paid back at a certain future date in time.
  • Do bonds pay dividends?
    Bonds do not pay dividends per se, although the interest payments that they pay are similar to dividends, other than the fact that these interest payments are of a fixed and known amount throughout the life of the bond, where dividend payments fluctuate according to the profitability of the underlying asset.
John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.