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.
So 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.