Investing in Bonds – The Basics
Vintage Bond Certificate
When people decide to invest their money in securities, they immediately think about putting their money in the stock market. The idea of investing in stocks and seeing huge returns is very exciting. People see and read stories about how stock prices rise by as much as 100 percent to 200 percent, with certain individuals having bought the stock when it was at its lowest price.
But not every stock market investor sees turns that high. In fact, many investors get burned because they take undue risks with their stock market investments. The risk increases further when you get an economy that is in a state of uncertainty. Even though the United States and world economy has recovered from the 2008 Financial Crisis, the picture is not exactly rosy either. Many sectors are still facing issues, and worldwide political uncertainty does not help stock prices either.
One only needs to look at the political situation in the United Kingdom and how it is impacting the stock market not only in that country, but in other parts of the world. Uncertain times are never far away, even if the stock market is going through a good period. It is why investors are always advised to diversify their investments.
While an investor can diversify through purchasing stocks of reliable companies in different sectors to hedge their bets, it is also sensible to invest in other types of securities. And bonds are a great way to put your money in a security that is fairly low risk, but will also give you a decent return. This article provides a deeper explanation of bonds, why you should consider owning them and the different types of bonds available right now.
What is a Bond?
A number of people think of bonds as another type of equity investment, but with lower risks. But it is a misconception that bonds are a form of equity. Bonds are a form of debt, with the person buying the bond being the lender. Bonds exist because organizations, whether they are public or private, need to raise money for various reasons. Whether it is a multi-national corporation, a local bank or a state government, they will issue bonds in the hopes of raising money so they can spend it on pending projects or other avenues.
But the entity requesting money through bonds must offer something to the other party in the transaction. No one is going to lend money to companies out of the goodness of their heart. But they will lend money if they receive a return at the end of the bond period. The interest rate on bonds is known as the coupon, which is set before the individual agrees to buy a bond. When the borrower pays back the bond to the lender, they will pay the amount borrowed along with the interest rate.
For example, a company may offer a bond with a value of $2,000, along with an interest rate of 10 percent. If the bond has a maturity of two years, the lender will receive an interest payment of $200 during each of the two years, along with the $2,000 at the end of the two-year term. By lending the entity $2,000, the individual ends up with $2,400.
Depending on the maturity of a bond, payments are structured in different ways. Some bonds pay interest annually, while others make semi-annual payments. It is important for the investor to check on all of these stipulations before they agree to buy a bond.
The biggest difference between a bond and stock is the fact that a stock provides the investor with part ownership in the company, while a bond is simply making the investor a creditor to the company in question.
Why Own Bonds
Given the fact that bonds are not as sexy or exciting as stocks, it is often difficult to convince new investors they should invest some of their money in bonds. New investors typically read about how stocks offer higher returns than bonds, on average, and conclude that they do not need bonds as part of their portfolio.
And while it is true that bonds are not going to give you a better return on stocks, on average, they are still a crucial part of diversifying an investment portfolio to hedge against the risk of your stock investments having a bad year or two.
Bonds are particularly great as part of retirement investments. If you are a wealthy individual who can afford to lose some of the money they invest into securities, you may not have too many qualms about having a stocks-only investment portfolio.
But investors who are depending on the money they invest to provide them with a retirement nest-egg cannot afford to lose this money through stock market volatility. By putting a certain portion of retirement funds, such as 30 or 40 percent, in bonds, individuals are significantly lowering the risk associated with their portfolio.
Most experts believe that an investor’s portfolio should include more stocks when they are younger. But as they get older, more of their portfolio should consist of a higher percentage of bonds, because they are a much safer investment.
The fixed earnings associated with low-risk bonds are also attractive to investors who may need the money within a shorter time frame. For example, an investor may want to put $100,000 they have saved up in an investment vehicle so they can see modest returns in a few years. They may want to use that money to get their MBA or attend graduate school. Investing in stocks may promise higher returns, but it can also cause the investor to end up with less than the $100,000 they originally had.
The investor can find a bond that not only offers great security, but also provides decent returns at the end of a two, three or five-year period. When the bond transaction is finalized, the investor knows exactly how much money they will have at the end of the bond’s period. This security can really help people who are depending on the money they invest for their future.
Face Value –
A bond’s face value, or par value, is the amount of money the bond holder receives when the bond matures. Bonds newly introduced to the market will almost always sell at the same value as the face or par value. But it is not uncommon for some bonds to sell for a higher or lower amount than the face value, depending on the market conditions at the time.
The coupon on a bond refers to the interest rate. It is referred to as the coupon because in the past, investors would tear off coupons from the physical paper they received for holding a bond and redeem those coupons for the interest payments. Since most bond transactions are now conducted electronically, the need to tear off coupons to redeem interest is no longer relevant, but the name has stuck!
Bonds will make interest payments every six to 12 months, with six months being the most common time-frame. The coupon is a percentage of the face value. For example, a bond with a coupon of 8 percent and a face value of $2,000 will pay $160 per year – or two $80 payments per year.
A bond’s maturity is the date when the investor must be repaid the face value. Each bond has a unique maturity date. Bonds have maturity dates ranging from 30 days to 30 years. Most investors will put their money in bonds with maturity dates ranging from one to ten years. Bonds maturing sooner are less risky, because it is easier to predict the issuing entity’s financial situation in one year, as compared to 10 or 30 years.
It is often an overlooked part of buying bonds, but it is very important to know who is issuing a bond. If you only look at the face value and the coupon, you may end up purchasing bonds that are a much higher risk than you had anticipated.
Bonds are given ratings by independent rating agencies to highlight their credit worthiness. Bonds with a AAA rating are deemed the highest quality, followed by AA, A, BAA/BBB, BA/BB and CAA/CCC. Bonds with a rating of below BAA/BBB are considered “junk bonds” and should be avoided.
If your biggest concern while investing in bonds is the risk associated with the transaction, it is a good idea to limit yourself to AAA or AA bonds.
Bond Basics Video
Types of Bonds
Government Bonds –
Governments around the world issue bonds to private citizens or companies who are willing to lend them money in return for interest payments. The United States government issues Treasury bonds, Treasury notes and Treasury bills. The United States government is one of the most trustworthy lenders when it comes to bonds, which is why most people who want a low risk bond will go with T-bonds, T-notes or T-bills.
Municipal Bonds –
Municipal bonds are not as low-risk as government bonds, but they are still fairly risk-averse. Cities rarely go bankrupt, especially ones with a good reputation, but it does happen from time to time. Bonds issued by municipalities in the United States are not subject to Federal tax, which offers some savings for investors. And many local governments will not put any local or state taxes on these munis either, making them completely free of taxes.
Corporate Bonds –
In the same way that companies issue stocks to raise money, they also issue bonds to borrow money from lenders. Large companies have no problem taking on millions of dollars of debt, because they have enormous equity to deal with the risk. Most large companies can offer as many bonds as they want, dependent on the demand in the market. Corporate bonds range from three to thirty years in their maturity.
Corporate bonds often come with higher interest rates, which makes them enticing to investors, but they also carry much higher risk. It is a general rule of thumb that corporations are much likelier to go bankrupt than national, state or local governments. But the risk of a corporate bond really depends on who is issuing them.
If you are buying corporate bonds from a company that has been around for 50 or 60 years and has always displayed a stellar financial record, you are not taking on much risk. But if you purchase a bond from a company that has only existed for three or four years, you are bearing as much of a risk as you would if you bought stock in the company.
Interest Rate Risk with Bonds
Interest Risk and Bonds
One of the most important rules regarding bonds pertains to interest rates. Whenever interest rates rise, bond prices will decline. And whenever interest rates go down, bond prices will go up. One of the biggest problems with buying bonds, especially those with ten to thirty-year maturities, is the fact that interest rates may rise during that period.
For example, an investor may purchase a bond worth $1,000 in 2016 and receive a coupon rate of 5 percent. If their bond has a maturity of ten years, they will continue to receive those interest rates for ten years. But the investor may need to liquidate some assets before ten years have passed. If they find themselves needing to sell the bond after seven years, they need to compete with newly issued bonds seven years from now.
If interest rates rise to 8 percent by 2023, the investor will have a hard time selling their bond when competing bonds will have much higher coupons. They will have to lower the price of their bond in order to sell it to another investor, which means they could lose money on the bond. This interest rate risk is one of the prices you pay for buying bonds with long-term maturities.
But the opposite can occur if interest rates decline during the seven years after the investor buys the bond. If interest rates decline to 2 percent, the investor may find that the value of his bond is higher than the face value.
Bond funds are an easy way to invest in bonds that does not require purchasing individual bonds from different entities. Bond funds offer a monthly income, along with the option to liquidate the bond at specified times. Here is a look at three major types of bond funds where you can invest your money.
Investment-Grade Bond Funds –
These bond funds will invest your money in government bonds, such as U.S. T-Bonds, municipal bonds, mortgage-backed bonds and other high quality “investment grade” bonds.
High-Yield Bond Funds –
For those investors who are looking to make more money through their bond investments, high-yield bond funds are a decent option. The downside to these funds is the fact that your money is being invested in securities with a lower credit rating. But these securities do offer a higher rate of return than the investment-grade bonds.
Multisector Bond Funds –
Multisector bond funds will invest your money in any type of bond they deem worthy at the time. They could invest the money in a combination of treasury, municipal, corporate or higher-yield bonds. If you are considering multisector bond funds, it is very important to do your research before making a final decision on the fund where you will put your money.