Bonds are one of the least understood instruments used in investing today by the general public. I admit I was unsure what exactly they were and how they work at first. But I have come to understand them and utilize them in my personal portfolio.
Did you know that in September of 2016 there was $773 billion of bonds traded? This is the average traded daily in the US. In the 3rd quarter of 2016 there were $1878 billion in bonds issued. I couldn’t believe that much was traded. That is just a huge number.
A large portion of that number is government traded bonds, some of which is purchased by the government the rest by us.
1. What is a Bond?
Have you ever borrowed money before? Like most of us, probably. That is what a bond is. It is a debt instrument that companies use to raise capital for projects or other needs of the business.
In simple terms, it is a device that is used to raise money for the business that needs the money to help fund a project or other expansions in other markets.
Bonds are issued by both companies and governments, either local or federal. Typically these are done by businesses that are too large to go to a bank to borrow a few billion or so. So the solution is to issue bonds to raise that money. These are done to public markets.
Thousands of people will give money to these institutions in the form of a loan. Bonds are really a loan in which you and the other investors are the lender. The bond issuer will or the company raising the money will issue you a bond as an IOU for the money that you lended them.
2. How do Bonds Work?
Naturally, you don’t lend your money for nothing so the company issuing you the bond must pay you something for the use of your money. The “something” comes in the form of interest payments. These would be set at a predetermined rate and schedule of payments. The interest rate would commonly be referred to as a coupon.
The face value or value of the bond that was borrowed will be paid back at the maturity date. Or the date established during the purchase of the bond. Bonds are typically referred to as fixed income securities because you know the date and amount of payments you will receive from them.
Let’s use and example to help us clarify this a little more. Say you purchase a bond with a face value of $1000 for 5% with a maturity date of 10 years. This means that for 10 years you will receive yearly payments of $50 in interest. $1000*5%=$50. And after 10 years you will receive your original $1000 loan back. Pretty neat huh!
3. What is a Bond’s Face Value
The face value or par value of a bond is the price affixed to it upon sale of the bond. The price of the bond will fluctuate according to the whims of the market. Typically the face value will be $1000, but there are some that are issued with a par of $100.
The prices of the bonds will rise and fall with the market and be sold at either a premium(increase) or a discount(decrease) from the par value. This can be a little confusing to those just starting out. Bonds are traded on the market just like stocks and the prices are dictated by the market. When they are initially offered you will pay the par value of the bond but if you buy or sell before the maturity. This will deteremine which price you would pay at that time.
4. What is a Bonds Coupon
A coupon is the bonds interest rate that is paid based on the par value of the bond. The rate or yield will change as the value of the bond changes.
The name coupon comes from the historical use of actual coupons that you could detach from the bond to redeem. The yield of the coupon was printed on the coupon for redemption.
The coupon rate is set at issuing of the bond but during the life of the bond the market rates will rise and fall. The rate will be fixed but as the interest rates rise or fall in relation to the coupon rate the price of the bond will rise and fall.
5. What is a Bonds Interest
The interest rate that is stated on coupon will be established by the issuer of the bond at the time of purchase. This rate will be fixed during the life of the bond. So if the coupon has a 5% interest rate for 10 years that is the rate that would be paid during those 10 years.
One of the main risks of investing in bonds is interest rate risk. This is the change in the bonds price based on a change in interest rates.
To make sense of how interest rates can affect the price of a bond. We need to discuss the term yield to maturity. This is simply the discount rate that can be used to make the present value of all the bonds cash flows equal to it’s price.
This means that bonds price is the sum of present value of each cash flow(coupon rate + par value) where the present value of each cash flow is calculated using the same discount rate.
This discount rate is the yield.
So when a bonds yield rises its price falls and conversely when a bonds yield falls its price rises. The longer to maturity the higher the yield will be.
Inflation is the death of bonds. Inflation erodes the future cash flows of the bond which will drive up the yields as investors demand a higher yield to offset the risk of rising inflation.
This means death to the bond because as we know the higher the yield rises the more the price falls which will hurt the future cash flows of the bond.
This one simple fact is causing the bond market to quake in its boots right now. As we all know the interest rates are at all time lows for the human race. And as these go up the prices of the bonds will deteriorate. Some fear that the bubble that has been created in the bond market will trigger another economic disaster. Bonds have been a safe haven for investors looking a safer place to invest since the latest stock market crash of 2008.
6. When do Bonds Mature
The maturity date will be the date that the original invsetment or loan will be paid back and when the interest payments will stop. So, the original $1000 you loaned the company will be paid back at the time establised on the bond.
One thing to keep in mind with fixed-income securities is that they can have a feature which makes them redeemable before their maturity date. This is referred to as “callable”. This means that the issuer can payback their loan at any time. Which would mean that you would get your principal back sooner, which is a good thing. Not so good would be that your interest payments would cease at this time.
Needless to say, it would be worth your time to inquire about this feature of the bond you are interested in before purchasing.
Maturity date is used to classify bonds into three categories.
- Short term-one to three years
- Medium term-four to 10 years
- Long term-over 10 years
The most common type of long-term bond would be the 30 Year US Treasury Bond.
7. Are Bonds fixed income
In a word. Yes. Bonds are considered the number one form of fixed income. This is because of the nature of their instruments. They are the preferred source of income for fixed income earners because of their stable cash flows and lower risk than stocks.
With the nature of bonds being a debt as opposed to an equity. There is less risk upfront and in the case of bankruptcies or liquidations you have some rights to protect your capital. Whereas if you invest in stocks and the worst case scenario occurs, you are out of luck. Stocks have no rights in a bankruptcy or liquidation.
The fixed income comes in the form of interest payments that you will recieve semiannually because of your investment in the bond. Right now with the rates so low just about any bond interest rate would be a better investment than any savings account out there. Keeping in mind of course the relationship between price and yield. And don’t forget our friend inflation.
8. Are Bonds Insured
One type of bond is insured. That would be the municipal bond. These are purchased, underwritten and packaged by a financial guarantee company who would sell it the investors.
These bonds are typically higher rated than other bonds and because of this they are able to offer insurance to those not able to purchase it. The premium for the insurance is passed on to the customer. These rates are typically extremely low because they are passed on to the investor thru lower yields.
All other types of bonds are uninsured at this time.
9. What Types of Bonds
- Government Bonds
- come in three flavors
- Bills-mature in less than one year
- Notes-mature in 1 to 10 years
- Bonds-mature in more than 10 years
- marketable securities from the US government follow this guideline. These are known as Treasuries and are considered extremely safe as they are backed by the full faith of our government.
- come in three flavors
- Bonds known as “munis” are issued by city governments and are considered very safe as well, given that local governents very rarely go bankrupt. But it has been happening a little more lately. Big advantage for these bonds is they are tax free from Uncle Sam. Also many local governments will make them tax-free for residents which would make these bonds completely tax-free. With the tax savings these bonds typically have a lower yield than taxable bonds.
- Corporate Bonds
- Bonds issued by companies to help raise capital.
- Typically higher yields because of higher risk
- Companies credit rating is extremely important. The higher the quality of credit the lower the yield will be on the bond.
- variations on corporate bonds would be callable bonds, which can be redeemed before the maturity date. Also there is the convertible bond which can be converted into common stock.
- Zero-Coupon Bonds
- This bond has no coupon but is issued at a considerable discount to par value. And example would be a $1000 bond issued with 10 years to maturity at the price of $600. This means that you would be purchasing a bond for the price of $600 that in 10 years would be worth $1000.
10. How Do I Purchase Bonds
Government bonds can be purchased thru the website treasurydirect.gov directly. This cuts out the broker or middleman. You can also use the website to check the value of each bond. They are redeemable at most major banks or thru the Treasury.
All other bonds can be purchased thru your broker or brokerage firm. As with purchasing stocks you need to do your due diligence to make sure you are making the right purchase.
11. Are They Safer than Stocks
Generally speaking, bonds are considered safer than stocks when dealing with investment grade bonds. Bonds issued by the federal government, highly-rated municipalities, and highly rated corporations have throughout history provided excellent safety of principal and terrific income.
12. Which Bonds Are Best to Invest In
Very loaded question, kind of like asking which child is your favorite. This is a totally personal preference. It would depend on your risk tolerance and what your goal would be with the purchase of a bond. If you are looking for something safer and lower yield then look no farther than a treasury bond.
If you like to live on the edge a little bit more than you could look at corporate bonds. These will have more upside but also more volatility or risk.
And if you are looking for the highest yield possibly and risk/volatility is not a detractor for you then junk bonds would be the way to go. Junk bonds are the lowest rated bonds out there and are very risky as they are issued by very unstable companies. They carry incredibly high yields to go along with extreme risk.
So again it comes down your preference and how these bonds can fit into your portfolio and plan.
13. Are there Tax Free Bonds
Yes, they are the municipal bonds or “munis”. These bonds are issued by local governments. The muni is tax-free from federal taxes on the income earned from the interest. And many muni’s are being offered as tax-free for residents of that city.
So all the breaks from taxes are great but the downside is these bonds have a lower yield than those offered by the federal governments. If you are high-income earner this detriment disappears. How is that you ask? Well, the federal tax-rate of 35% is eliminated with the muni so the lower yield for you would be higher because you wouldn’t have the reduction of yield based on a high tax rate.
14. How are Bonds Priced
This is an extremely complicated process that could be an entire post in itself. But to sum it up in a simple way. The pricing of a bond is dependent on the state of the economy. It all boils down the interest rates at the time.
When interest rates fall, the prices of bonds in the market rise. And likewise when the interest rates rise, the prices of bonds in the market fall.
15. How do Bonds Affect Stocks
Bond prices and stock prices move in opposite directions. When the stock rises people sell their bonds to take advantage of stock prices and conversely when stock prices fall, they sell their stocks to buy bonds.
So as the economy is doing well people will invest in stocks and sell their bonds because as interest rates rise bond prices will fall. And as the economy sours and money is tight and interest rates fall people will sell their stocks and put their money into bonds because prices will rise and they are looking for the steady income from a bond.
16. Why are Bonds a Good Investment
Bonds are a safe and stable investment. They are a consistent stream of income, even during a stock downturn. Because of the nature of their structure they are a great place to invest when you don’t want to have a lot of volatility.
17. What are Bonds a Bad Investment
Right now bonds are not a great investment because the interest rate environment is so low. The only place for interest rates is to go is up and when they do the prices of bonds will fall like a rock.
Investors have piled into bonds the last few years with interest rates being so low and as we know from our studies here that when rates climb the prices of bonds will fall. There is a bubble out there in the bond market that is just waiting to burst, so that is why waiting to invest in bonds right now would not be a good idea.
18. Who Rates Bonds
Bond rating agencies like Moody’s have analysts who study the issuers assets, debts, income, expenses and a financial history.
The rating agencies use a rating scale from Aaa to C, with Aaa being considered the best. Only bonds with a rating Baa or above are considered investment grade.
Bond ratings are reviewed every six to twelve months, but they can be reviewed at any time the agency thinks it is warranted based on changes in any of the financials.
There are three major agencies that rate bonds.
- Standard & Poors (S&P)
19. Where are Bonds Listed
Like with stocks, bonds are traded in the primary market and in the secondary market. But the difference is that bonds are traded over the counter as opposed to exchanges like stocks. The reason for this is that bonds are very diverse.
Over the counter means that there is no central exchange and are typically handled through various communications channels like electronically, telephone or email.
Stocks have only two types, while bonds have many different yields, maturities, and qualities. This means there are more issuers and issues of bonds with many different characteristics which makes it difficult to trade bonds on exchanges.
Another reason would be the difficulty in pricing. Because bonds are priced according to the current interest rates and credit ratings this can make it difficult to trade them on the stock markets.
20. Bonds with aaa Ratings.
These are the bonds with the highest level of creditworthiness. They have exceptional financials and can easily meet their commitments. Because these bonds have the lowest chance of defaulting on their loans and have the lowest risk they also have the lowest yield of any bonds.
As of April 2016, there are only two Aaa rated bonds out there right now. Exxon Mobil was recently downgraded because of low gas prices and that leaves two companies as of now. The two are:
- Johnson & Johnson
As recently as 2008 there were six companies but General Electric, Pfizer, and ADP were downgraded which leave us with just the two.
Aaa are kind of a rare breed and extremely secure in their financials. Notice you don’t see Apple, Amazon, Facebook, Walmart among some the other big corporations.
Gurus who specialize in Bond Investing
Long considered one of the “kings of bond investing” He co-founded Pacific Investment Management or PIMCO. He also ran PIMCO’s Total Return Fund (PTTRX) which had $270 billion to manage. He left PIMCO to join Janus in 2014 and he has a wonderful newsletter that he sends out once a month. He shares his thoughts on the status of the economy as well as numerous thoughts on investing. Definitely worth checking out.
He is the founder of the largest hedge fund in the world with over $15o billion in assets under management. He began investing when he was 12, buying shares of Northwest Airlines for $300. In 2007 he predicted the coming global depression and in 2008 he published an essay “How the Economic Machine Works”. He has also published several books among them the wonderful Principles. Also a must see is his YouTube animated video that he narrates called the How the Economic Machine Works.
He was formerly the head of the $9.3 billion Total Return Bond Fund(TCW), where he finished in the top 2% of all funds invested in intermediate-term bonds for the 10 years that ended prior to his departure. He immediately founded his own firm, Doubleline Capital with members of the senior staff from TCW. In 2011 he was named “king of the bond market” by Barrons magazine.
Bonds are such a interesting investing tool. They are such an unknown commodity to general public. But they have so many great characteristics that people could take advantage of. My hope with this post was to help educate you about bonds and what they can do for you.
Some important points to remember about bonds are.
- they are a loan you are giving to the issuer.
- the issuer will give a coupon or a percentage of the bond during the course of the life of the bond, which you will be paid semi-annually
- the price is fixed at the issue of the bond and is called par value
- prices can flucuate in the market
- the price of a bond is dependent on the credit rating of the company issuing the bond, plus the current interest rates
- as the interest rates rise the price of the bond will decline and as the rates fall the prices will rise-think of a see-saw
Bonds are a great conservative investment that you should consider for your portfolio. However right now would be a time to be very cautious. The current interest rate environment is very tenous at best. With all signs pointing to a rise in rates in the near and distant future, I would caution you to be very selective with your bond purchases. Remember that as the interest rates rise the prices will fall, meaning you would be losing value of your bonds.
This has been a fun, interesting post to create and I hope you have learned something here. If you think this could be of benefit to someone please share it with them.
As always, thank you for taking the time to read this post.
Until next time,