Bonds are often considered to be a safe investment by many people. Sometimes they are called fixed-income investments as they give a steady rate of return. Understanding how they work and how they fit into an investment strategy can help you manage your portfolio better. Adding bonds to your portfolio is a great way to diversify, reduce risk, preserve capital, and create a steady stream of income.
If you are an investor and consider adding bonds to your portfolio, this ultimate guide covers everything you should know about them.
What Are Bonds?
Bonds are an asset class and represent loans given by an investor to a borrower in exchange for a return. They are fixed-income investment vehicles and are issued by governments, municipalities, corporations, and banks to fund their projects, finance their existing debts, or provide cash flow for their daily operations.
Investors buying bonds are creditors of the issuer. These lenders have legal and financial claims to the debt fund. Issuers, borrowers, are liable to pay the bond’s full face value to the lenders at the expiration of the term, also called the maturity date. In addition, the borrowers are also liable to pay interest on these loans to the lenders. The interest rate charged is called the coupon rate and is usually a fixed rate.
How Do Bonds Work?
When companies or governments require raising money for their existing operations or new projects, one of the options they have to raise funds is by issuing bonds to the public. The issuer issues the bond, including the interest rates and payments, terms of the loan, and the maturity date.
Investors earn fixed-rate interest payments for lending their funds to the issuer. Thus, investors can hold on to their bonds until the maturity date, get regular interest payments, and get back the face value at the maturity date. Many investors, though, sell bonds before they mature on the secondary market. They are either traded publicly on exchanges or privately between the lender and the borrower. As bonds can be resold, the value of a bond can rise or fall before it matures.
Face Value – Also known as “par value,” is the amount the bond is worth when it is issued. It is also the amount that will be returned to the investor when it matures. Most bonds typically have a face value of $100 or $1,000.
Coupon Rate – This rate is the interest rate the borrower pays on the capital invested by the bondholder. It is expressed as a percentage, and in most cases, it is a fixed rate and won’t change after the bond is issued.
Coupon Dates – The dates on which the investor gets his interest payments are called coupon dates. The standard interval is semi-annual, though payments can be made at any interval.
Maturity Date – This is the date on which the bond term ends, and the issuer pays the principal value to the bondholder.
Bond Yield – This represents the return on a bond expressed as a percentage. There are different ways to measure yield, but the simplest formula is:
Current yield = coupon amount / price.
When the price changes, so does the yield.
What Determines a Bond’s Interest Rate?
Bond issuers determine a bond’s interest rate, also called the coupon rate, based on 2 factors, time to maturity and credit quality.
If the bond issuer has a poor credit rating, risks are higher, and as a result, it pays a higher coupon rate. A bond with a long maturity date also has a higher coupon rate because the bondholder is exposed to inflation risk and interest rate risk for an extended period of time.
The coupon rate is expressed as an annual percentage of the face value of the bond. For example, a $1,000 bond with a 10% annual coupon pays $100 of interest every year until the maturity date. Most bonds have fixed interest rates. Some have variable or floating interest rates. This means that interest rates change periodically. They are expressed as a percentage spread over a benchmark rate—for example, LIBOR plus 1/2%.
A bond that that does not have a coupon rate is called a zero-coupon bond. It is sold at a discount of its face value.
If you plan to hold onto the bond until maturity, the price that you need to worry about is the face value. This is the value you will get when the bond matures.
However, investors can also buy and sell bonds in the secondary market. After bonds are initially issued on the primary market, the price will fluctuate as a stock price would.
A bond’s price can keep changing when the interest rates in the economy change. It is also influenced by its maturity date, face value, currency, creditworthiness, and yield. As a result, the market price of a bond varies throughout its life.
When interest rates rise, the price of a bond in the market falls, and the yield of the older bond rises. This will bring it in line with the newer bonds that are issued with a higher coupon rate. Conversely, when interest rates fall, the prices of bonds in the market rise and the yield of the older ones decreases, bringing it in line with the newer ones being issued with a lower coupon rate.
Here is an example: A bond is issued with a face value of $1,000, a coupon rate of 10%, and a maturity of 10 years.
If the investor holds on to the bond until maturity, the yield will be $100/$1,000 = 10%.
However, if the investor decides to sell it before its maturity date, the investor most likely will not get $1,000 because the interest rates have increased. This bond is selling at a discount in the market at $700. This will make the bond yield $100/$700 = 14.29% and bring it in line with newly issued bonds with a coupon rate of 14.29%. Please note that the coupon does not change regardless of the price of the bond.
If interest rates had gone down, the bond could have sold at a premium of maybe $1,300, which would make the yield $100/$1,300 = 7.69%.
Bonds and the stock market
When the stock market is doing well, investors are less interested in purchasing bonds, so their value drops. This results in issuers offering higher interest payments to attract bond purchasers. When the economy is expanding, the value of bonds goes down.
When the economy declines, investors will buy bonds and be willing to accept lower yields to preserve their capital. As a result, the demand for bonds in the secondary market will increase, and their price will increase above their face values. The interest payment is now a lower percentage of the initial price paid, hence a lower yield.
Bonds can be categorized into different types based on who issues them, the risk involved, and their maturity term. The most common classification is by the issuer. There are 4 main types of bonds sold in the market.
Government bonds – A government bond is a debt issued by a government and sold to investors to finance big projects or support day-to-day spending. U.S. Treasury bonds are some of the most secure in the world, and they make up the largest segment in the United States bond market. The income from interest paid on government bonds is exempt from income tax at the state and local level but not from federal tax.
Many countries issue government bonds. However, please be aware that ones issued by other countries, especially in emerging markets, will be a lot riskier. Those risks include country risk, political risk, and central-bank risk.
Municipal Bonds – Also called munis, are issued by government entities such as states and local governments. These munis have slightly higher interest rates, and therefore offer a slightly higher return than government bonds. Munis are riskier than government bonds, but besides the higher return to the investor, they have another advantage.
The interest earned on a muni is exempt from federal income tax. Sometimes the interest is even exempt from state and local tax if you live in the state that issued the bond. This type of bond is called double tax-free. However, because of its tax advantages, it typically pays a lower coupon than a taxable bond.
Corporate bonds – Private and public companies issue these as an alternative to seeking bank loans. They have lower interest rates than bank loans and often offer favorable loan terms. Corporate bonds account for the second-largest segment of the U.S. bond market. They are riskier than government bonds as companies cannot raise taxes to pay for their debt. The risk and return depend on how creditworthy the company is. Junk bonds are high-yield bonds with low credit ratings. They are corporate bonds that have the highest return potential but also carry the highest risk.
As a corporate bondholder, you do not own equity in the company as you do as a stockholder. You will only have a right to the interest payments and the principal on the bond. You will have no right to any of the company’s profits. However, if the company goes bankrupt, bondholders have priority over shareholders in claims on the company’s assets. Of course, this is still no guarantee as there always is a risk the company cannot pay its debt after bankruptcy. This default risk is an important concern to bondholders. Investors can try to reduce this risk by checking the company’s creditworthiness before investing in the company.
Government agency bonds – Some agencies of the U.S. government issue bonds as well. Some are fully backed by the government and are almost as safe as Treasuries. They have high liquidity but are taxable at both the federal and state level. An example of government agency-issued bonds are Fannie May Bonds.
Another type that is often talked about is savings bonds. These are low-risk, long-term bonds with maturity periods of up to 30 years. The interest accumulates and is paid at maturity. They cannot be sold on secondary markets.
U. S. Treasuries
The federal government issues United States Treasuries through the U.S. Department of the Treasury. They are fully backed by the government or, as they say, “carry the full faith and credit of the U.S. government.” Thus, they are the safest possible bond investment. However, their yield is very low. In addition, treasuries are very liquid, but their payments may not keep up with inflation.
There are 4 types of treasuries:
- Treasury bills – Short-term securities maturing in 1 year or less. They do not pay interest but instead are sold at a discount on the face value. This means that the investor pays less than face value when purchasing the bond. However, the investor gets the full face value when the bond reaches maturity.
- Treasury notes – Securities with maturities of two, three, five, seven, and 10 years. They pay interest every six months.
- Treasury bonds – Long-term securities that typically mature in 30 years and pay interest every six months.
- TIPS – Treasury Inflation-Protected Securities have maturities of five, ten, and 30 years and pay interest every six months. The principal or face value of TIPS is adjusted for inflation based on changes in the Consumer Price Index.
Besides categorizing bonds by the issuer, various other types are worth mentioning.
Zero-Coupon bond – This type of bond does not pay any interest but is issued at a discounted price. This means that the investor pays less than face value when buying the bond but gets the full face value when the bond matures. A U.S. Treasury bill is a type of zero-coupon bond.
Convertible bond – These are corporate bonds that offer the investor the option to exchange them for a pre-determined number of shares in the issuing company. They have lower interest rates as they offer investors an opportunity to get a share of the company’s profits if the company is successful. However, if the company is not successful, the investor does not convert them to stocks but is stuck with the bonds’ sub-par returns.
Callable bond – Also called redeemable bonds. Generally, most callable bonds are corporate or municipal bonds. This type of bond gives the issuer the right to redeem them before their maturity date. For example, callable bonds will be issued if the borrower expects lower interest rates in the future but still wants to issue them. However, when the interest rates drop, the issuer will redeem the callable bonds and issue new ones with lower interest payments.
Such a bond is riskier for the bondholder because it can be called back when it rises in value, and the investors will lose some future interest payments. As the risk is higher for the investor, the borrower has to pay a premium at higher coupon rates.
Puttable bond – This kind of bond gives the investor the right, but not the obligation, to sell it back to the issuer for the early repayment of the principal. This is a good option for investors who are afraid that the value of the bond will decline. A puttable bond can be redeemed at previously agreed upon occurrences of specified events or conditions or at a certain time or times.
Reasons for Buying Bonds
There are three main reasons for buying bonds:
Most investors use bonds to generate a steady stream of income. As the coupon payments are fixed, investors know how much they will get at what time. This makes them ideal for funding plans like education or retirement.
Reduced Portfolio Risk
You can also use bonds as a way to reduce the overall risk of your investment portfolio. They are safer than stocks, but they offer a lower return. This is because bonds and stocks have a somewhat inverse relationship. When the stock market and share prices are generally high, bonds are down. Likewise, when the economy is booming, stocks do well, but the stock market goes down when the economy is declining. On the other hand, bonds go up because investors prefer the regular interest payments guaranteed by bonds. This is why some high-quality bonds like those issued by the government can help diversify the risks of investing in stocks.
Investors use bonds to preserve their capital. Bonds issuers are obligated to pay interest and repay the amount once it matures. If they are issued by corporations, creditors are paid before shareholders. Therefore, when compared to stocks, bonds are safer investments.
Types of Bond Risks
Risk is an inherent part of investing. Generally, investors must take greater risks to achieve greater returns, although taking an additional risk does not always lead to greater returns. Bonds are considered to be one of the safer forms of investment. However, they are not without risks. The risks associated with bonds depend on many variables, such as who issued them, their maturity, and the state of the economy. Here are some of the different types of risks investors should be aware of before investing in bonds:
Credit risk – The biggest risk to bond investors is that the issuer is unable or unwilling to make timely interest payments and pay back the principal at the maturity date. This is called credit risk. Bonds are issued a credit rating, and the lower a bond’s rating, the higher the risk the debt will not be paid on time or not at all.
Default risk – This refers to the chance that the bond issuer fails to make the required coupon payments or principal repayment to its bondholders. For U.S. treasury bonds, this risk is virtually zero. For corporate bonds, the default risk can change over its lifetime as its financial situation changes over time. Investors can reduce this risk by evaluating a company’s cash flow and the company’s credit rating.
Interest rate risk – Also called market risk. This is the risk where changes in interest rates in the market may reduce or increase the market value of a bond. Since bonds and interest rates have an inverse relationship, as interest rates rise, the value/price of a bond falls. Therefore, interest rate risk increases the longer an investor holds on to a bond. However, if the investor has no intention of selling the bond, interest rate risk is irrelevant as at maturity, the investor will get the full principal of the bond.
Inflation risk – Unless the bond has some embedded inflation protection, a bond will be negatively affected by higher than expected inflation rates. High inflation reduces the purchasing power of a bond at maturity. This means that at maturity, the principal value of the bond in absolute value is the same, but in relative value is lower. This results in investors being able to purchase less with the principal that they will get back than expected.
Liquidity risk – Liquidity risk is the ability to sell a bond quickly at a good price. Liquidity risk will only be an issue if an investor plans to sell the bond before the maturity date. While U.S. treasuries are almost always easy to sell as there is a large market for them, the market for corporate bonds is sometimes a very thin market with few buyers and sellers and might force investors to sell bonds at a lower than expected price.
The U.S. Securities and Exchange Commission (SEC) requires bond issuers to file a prospectus that describes the bond’s terms, including a bond’s credit rating.
Bonds get rates on their overall risk by credit rating agencies such as Moody’s, Fitch, and Standard & Poors. These agencies evaluate the creditworthiness of the issuer and the chances they will be able to pay the interest and the principal on time. Creditworthiness is based on factors like past payment records, history of available cash flow, and the future outlook of the issuer in the industry. Based on this assessment, the issuer gets a credit rating for the bond.
Bonds are categorized into investment-grade and non-investment-grade bonds. The very highest quality bonds such as U.S. Treasuries and bonds from very stable companies are called investment-grade and are rated BBB or Baa and above. These bonds have lower yields than non-investment grade ones. Non-investment grade bonds, also called junk bonds, are riskier, low-quality investments with higher yields to offset the increased risk of investing in them. Junk bonds are rated C or lower.
Ways to Reduce Risk
Create Bond Ladders – One of the best ways to reduce risk when investing in bonds is to use Bond Ladders. It is a bond portfolio with each step of the ladder representing a bond with varying maturity. For example, consider a 3-year bond ladder with bonds that mature in one, two, and three years.
A bond matures in the first year, and the investor can reinvest it in a new 3-year bond. This way, there is always a ladder of one, two, and three-year bonds. Ladders ensure a steady flow of income and help deal with the interest rate changes because the amounts are always reinvested in new bonds.
Stick to investment-grade bonds – Another way to reduce risk is to pay attention to the creditworthiness of the bond, which gives an idea of the probability of default. Higher-rated bonds and investment-grade bonds have lower risks.
Diversification – Diversification is another key consideration to reduce bond risks. Investors should try to achieve a balance between low-risk defensive bonds such as Treasuries and high-yield corporate bonds to manage risks. However, as an investor, it is very time-consuming to create a portfolio of individual bonds that is diversified and well-balanced. Luckily, an investor also can diversify by buying ETFs and mutual funds that hold a large number of bonds in a single fund. These funds can save the investor a lot of time. However, there are extra costs involved when buying ETFs and mutual funds.
Investing in bonds is very different than investing in stocks. Instead of buying part ownership in a company, buying a bond means extending credit to the government or a company for a fixed period of time. In return, the bond issuer will pay interest on that loan to the investor.
Bonds are low-risk investment options that deliver several benefits to the investor. They are a safe way to create a steady income stream and diversify a portfolio to reduce risk. A well-diversified portfolio should include a certain percentage in bonds. The percentage depends on the age of the investor and the risk the investor is willing to take. The percentage of bonds in a portfolio should generally go up as an investor nears retirement age. Adding a bond portfolio of highly-rated bonds of various maturities will be a good strategy when an investor is getting older.
Before investing, investors should identify their investment objective, consider the terms, and analyze the risks.