Bonds are especially useful if you are attempting to build a risk-averse portfolio.
Although bonds are far from risk-free, many people use them to balance risky stock picks in their portfolios. So even if you only have a small percentage of bonds in your portfolio, you should still understand what they are.
Definition of a Bond
A bond is a loan between a borrower and a lender. As the investor, you would essentially buy an I.O.U. note from a borrower. The note will include the term of the loan, the payment schedule, and any other relevant details.
The bond boils down to a promise from the borrower to the lender to pay you back in full, plus interest.
Who issues bonds?
Any organization can issue them. The typical institutions that issue bonds are large companies, the federal government, cities, and states.
The issuer of the bond will often explain why they need the money. For example, the government may need it to build new roads, or a company may need it to fund new research. The reason behind the issuance of bonds varies, but for one reason or another, the organization needs money.
Types of Bonds
There are several types of bonds, including:
- Corporate bonds: These are issued by companies and can be traded on public markets. They are used to raise capital for business operations, expansion, or to refinance debt.
- Municipal bonds: These are issued by cities, states, and other local governments to finance public projects such as schools, highways, and utilities. They are tax-exempt, which means the interest paid to investors is not subject to federal income tax.
- Treasury bonds: These are issued by the federal government and are considered to be among the safest investments because they are backed by the full faith and credit of the U.S. government.
- High-yield bonds: Also known as “junk bonds,” these are issued by companies with lower credit ratings and therefore carry a higher risk of default. They offer higher interest rates to compensate for this risk.
- Convertible bonds: These are bonds that can be converted into a predetermined number of shares of the issuing company’s stock. They offer the potential for capital appreciation in addition to the interest paid to bondholders.
- Zero-coupon bonds: These are bonds that do not pay periodic interest to bondholders. Instead, they are issued at a discount to their face value and the bondholder receives the full face value at maturity.
- Floating-rate bonds: These are bonds whose interest rate is tied to a benchmark rate, such as the London Interbank Offered Rate (LIBOR). The interest rate on floating-rate bonds adjusts periodically based on changes in the benchmark rate.
Are all bond issuers the same?
No. It may be obvious, but some issuers are more trustworthy than others.
Generally, U.S. government bonds are considered the safest possible bond. Many deem these bonds as practically risk-free. Of course, there is always risk involved, but it is rather unlikely that the U.S. government would default on its loan to you. Less trustworthy issuers are shady companies that you don’t trust.
A risky bond issuer will be forced to offer a higher interest rate than a stable issuer. That is because it is less likely that they will be able to repay the loan of the investor. If that happens, then the investor will lose their money. Bonds that offer high interest rates are considered junk bonds. That is because it is likely that the issuer will be unable to repay their investor.
The U.S. government offers the lowest interest rate on its bonds. That is due to the fact that they are most likely to repay the investor. Stable private companies will fall somewhere in between. Bonds that offer lower interest rates are considered investment-grade bonds.
How does a bond work?
When an organization needs money, it will issue bonds with the terms already set. As an investor, you will need to accept the terms or pass on the bond. The details of the bond will include the exact terms of the bond. Let’s look at what will be included in each bond offering.
- Issue price – The issue price is the price that the investor will have to pay for the bond.
- Face value – Typically, the face value of a bond is a nice whole number like $100 or $10000. It is unlikely that you would find a bond available for $99.47.
- Coupon rate – A coupon rate is equivalent to the interest rate that is on the bond. The issuer of the bond will pay this rate of interest to the investor.
- Coupon date(s) – Throughout the lifetime of the bond, the issuer may be required to make payments to the investor. The coupon dates will outline the amount of these payments and when they need to be made.
- Maturity date – A maturity date is basically the end of the bond. On this date, the issuer of the bond must pay the face value of the bond to the investor.
When you have all the information, you will be able to make an informed decision about a bond purchase.
What impacts bond prices?
Many things go into the price of a bond, but these are the most common.
Issuer’s credibility. If a shady company is offering a high yield bond, it will likely be classified as a junk bond. The risk will be reflected in the price of the bond.
Maturity date. The longer you have to commit your money to the bond, the higher the yield you will receive. The bond issuer is paying for the long-term use of your money.
Interest rates. Interest rates have the largest impact on bond prices. Higher interest rates will lead to lower bond prices.
Are bonds a risk-free investment?
No. Some bonds are significantly riskier than others. If a bond offers a high yield, then it is likely a risky investment.
Some people associate bonds with guaranteed returns. That is just not the case. You can lose money through bond investment. However, if you choose your bonds carefully, then this may be less of a worry. For example, if you choose to stick with U.S. Treasury bonds, then it is likely that your money will stay safe.
How does an investor make money with bonds?
When you purchase a bond, you can make money in a couple of ways.
First, you will receive interest payments regularly based on the coupon rate of the bond.
Second, you can sell the bond for more than you paid for it. If interest rates go down, then bond prices will rise. At that point, you will have the option to sell your bond for a profit before maturity.
How to Buy Bonds
There are several ways to buy bonds:
- Directly from the issuer: Some bonds, particularly municipal and Treasury bonds, can be purchased directly from the issuer. This may be a suitable option for investors who want to hold the bonds until maturity and receive the full face value.
- Through a broker: Investors can also purchase bonds through a brokerage firm. Brokers can help investors find the bonds that best match their investment goals and risk tolerance, and handle the transaction on their behalf.
- On a bond exchange: Some bonds, such as corporate bonds, are traded on public exchanges, similar to stocks. Investors can buy and sell these bonds through a brokerage account or through a bond exchange-traded fund (ETF).
- Through a mutual fund or ETF: Investors can also invest in bond mutual funds or bond ETFs that holds a diverse portfolio of bonds. This can be a convenient way to gain exposure to a variety of bonds without having to purchase them individually.
Before buying any bonds, carefully consider the issuer’s creditworthiness, as well as the terms and conditions of the bond. It’s also a good idea to diversify your bond holdings to reduce risk.
Investing in bonds is one way to diversify your portfolio.
Remember, bonds are not entirely risk-free. Do not assume that you will make money on a bond investment. It is entirely possible to lose money by investing in bonds.
Before you make any decisions about investing in bonds, research your options. It is important to understand all the risks involved before you choose to invest your hard-earned money.