Investors buy bonds because they provide a safe, predictable income stream and can balance the risks posed by volatile but higher-yielding stocks and other, riskier portfolio assets. Investors also purchase bonds to earn interest on a regular basis until their original capital is returned. Bonds are a type of fixed-income investment, which is a broad asset class. Other types of investments include cash, stocks, real estate, commodities, and derivatives.
How Do Bonds Work?
The borrowing organization promises to pay the bond back at an agreed-upon date. Until then, the borrower makes interest payments to the bondholder. People who own bonds are also called creditors or debtholders. In the past, when people kept paper bonds, they would redeem the interest payments by clipping bond coupons. Today, this process is all done electronically. The debtor repays the principal, called the “face value,” when the bond matures. Most bondholders resell bonds before they mature at the end of the loan period. They can only do this because there is a secondary market for bonds. Bonds are either publicly traded on exchanges or sold privately between a broker and the creditor. Because they can be resold, the value of a bond rises and falls until it matures.
Bond Elements
Bonds have several common aspects that investors should be familiar with, including:
Issuer: Any legal entity that seeks to raise money by selling securities such as bonds to fund new projects or investments, or to expand operations. Face value: Also known as “par value,” this is a static value assigned when a company brings stock or a bond to market. Unlike market value, face value doesn’t change. You’ll find the par value printed on the stock or bond certificate. Coupon rate: The nominal or stated rate of interest on a fixed-income security, like a bond. This is the annual interest rate paid by the bond issuer, based on the bond’s face value. These interest payments are usually made semiannually. Issue date: The issue date is the date on which a bond is issued and begins to accrue interest. Maturity date: The date on which you can expect to have your bond’s principal repaid. It is possible to buy and sell a bond in the open market prior to its maturity date. Keep in mind that this changes the amount of money the issuer will pay you as the bondholder, based on the current market price of the bond. Price: As a bond’s price fluctuates, the price is described relative to the original par value, or face value at which it was sold; the bond is referred to as trading above par value or below par value. Yield: The discount rate that links the bond’s cash flows to its current dollar price.
Example of How Bonds Work
Imagine Coca-Cola Co. wanted to borrow $10 billion from investors to acquire a large tea company in Asia. It believes the market will allow it to set the coupon rate at 2.5% for its desired maturity date, which is 10 years in the future. It issues each bond at a par value of $1,000 on its issue date and promises to pay pro-rata interest semiannually. Through an investment bank, it approaches investors who invest in the bonds. In this case, Coke needs to sell 10 million bonds at $1,000 each to raise its desired $10 billion before paying the fees it would incur. Each $1,000 bond will receive $25 per year in interest. Because the interest payment is semiannual, it will amount to $12.50 every six months. If all goes well, at the end of 10 years, the original $1,000 will be returned, and the bond will cease to exist.
Types of Bonds
There are many different types of bonds. They vary according to who issues them, length until maturity, interest rate, and risk. The safest are short-term U.S. Treasury bills, but they also pay the least interest. Longer-term Treasurys, like the benchmark 10-year note, offer slightly less risk and marginally higher yields. TIPS are Treasury bonds that protect against inflation. Municipal bonds are issued by cities and localities. They return a little more than Treasurys but are a bit riskier.
Other Types of Bonds
In addition, some other kinds of bonds are offered for sale in the marketplace. They include:
Zero-coupon bonds: Bonds that do not pay interest during the life of the bonds. Instead, investors buy zero-coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond matures.Convertible bonds: Can be converted into a different security—typically shares of the same company’s common stock. In most cases, the holder of the convertible determines whether and when to convert. At times, the company may determine when the conversion occurs.Callable bonds: Also known as redeemable bonds, these can be redeemed or paid off by the issuer prior to the bonds’ maturity date. When an issuer calls its bonds, it pays investors the call price (usually face value) along with accrued interest to date and, at that point, stops making interest payments. Sometimes a call premium is also paid. Call provisions are often a feature of corporate and municipal bonds.
Pros Explained
Can generate income through interest or resale: Bonds can generate steady income in your portfolio and pay off in two ways: through interest payments and repayment of your principal at maturity. Also, you can profit if you resell the bond at a higher price than you bought it. Sometimes bond traders will bid up the price of the bond beyond its face value. Safe, reliable investment: Bonds are considered a safe holding because you can’t lose your investment unless the issuer defaults. They help diversify risk in portfolios.
Cons Explained
Lower return than stocks: Over the long haul, bonds pay out less return on your investment than stocks.May not outpace inflation: One risk with bonds is that you might not earn enough to outpace inflation. Investing only in bonds might not enable you to save enough for retirement.Potential for issuer to default: Companies can default on bonds. That’s why you need to check the issuer’s S&P ratings. Bonds and corporations rated BB and worse are speculative. They could quickly default. They must offer a much higher interest rate to attract buyers.Bond yields can fall: Usually, when a bond’s price rises, possibly due to increased demand or falling interest rates, its yield, or investment return, decreases. This is viewed as a sign of a slowing economy. When this happens, the holder may realize a decreased return on the bond.
Types of Bond Risk
Although generally considered safe, bonds do present some risk.
Credit Risk
Credit risk refers to the probability of not receiving your promised principal or interest at the contractually guaranteed time due to the issuer’s inability or unwillingness to distribute it to you. Credit risk is frequently managed by sorting bonds into two broad groups—investment-grade bonds and “junk” bonds. The very highest investment-grade bond is a Triple-A-rated bond.
Inflation Risk
There is always a chance that the government will enact policies, intentionally or unintentionally, that lead to widespread inflation. Unless you own a variable-rate bond, or the bond itself has some sort of built-in protection, a high rate of inflation can destroy your purchasing power. By the time you receive your principal back, you may find yourself living in a world where prices for basic goods and services are far higher than you anticipated.
Reinvestment Risk
When you invest in a bond, you know it’s probably going to be sending you interest income regularly. However, you cannot predict ahead of time the precise rate at which you will be able to reinvest the money. If interest rates have dropped considerably, you’ll have to put your fresh interest income to work in bonds yielding lower returns than you had been enjoying.
Liquidity Risk
Some bonds are far less liquid than blue-chip stocks. This means that once you acquire them, you may have a difficult time selling them at top dollar. As a result, it’s wise to limit your purchases of individual bonds, unless you intend to hold them until maturity.
Bond Yield vs. Bond Price
For many people, valuing bonds can be confusing. They don’t understand why bond yields move inversely with bond values. In other words, the more demand there is for bonds, the lower the yield. That seems counterintuitive. The reason lies in the secondary market. As people demand bonds, they pay a higher price for them. But the interest payment to the bondholder is fixed; it was set when the bond was first sold. Buyers on the secondary market receive the same amount of interest, even though they paid more for the bond. Put another way, the price they paid for the bond yields a lower return.
What Bonds Say About the Economy
Because bonds return a fixed interest payment, they look attractive when the economy and stock market decline. When the business cycle is contracting or in a recession, bonds are more attractive.
Bonds and the Stock Market
When the stock market is doing well, investors are less interested in purchasing bonds, so their value drops. Borrowers must promise higher interest payments to attract bond purchasers. That makes them countercyclical. When the economy is expanding or at its peak, bonds are left behind. When bond yields fall, you can tell that the economy is slowing. When the economy contracts, investors will buy bonds and be willing to accept lower yields just to keep their money safe. Those who issue bonds can afford to pay lower interest rates and still sell all the bonds they need. The secondary market will bid up the price of bonds beyond their face values. The interest payment will then be a lower percentage of the initial price paid. The result? A lower return on the investment, hence a lower yield.
Bonds and Interest Rates
Bonds affect the economy by influencing interest rates. Bond investors choose among all the different types of bonds. They compare the risk versus reward offered by interest rates. Lower interest rates on bonds mean lower costs for things you buy on credit. That includes loans for cars, business expansion, or education. Most important, bonds affect mortgage interest rates.
