Bonds occupy a unique space in the investment world. Although they have a great deal to offer any portfolio, many investors have only a passing awareness of them.
Learning what bonds are, how they work and how they can be used to balance your financial portfolio can put you ahead of the financial curve.
At their core, bonds are loans that investors provide to an entity seeking capital. The entity may be a federal, state or local government body, a corporation or any other legally recognized body. Like other loans, bonds involve a fixed time period in which the borrower must repay the loan with interest. Interest rates may be fixed over the life of the bond or they can be variable.
When a corporation or government wants to borrow money, it issues bonds. Independent investors purchase those bonds, providing the money that the issuer is seeking. In return, the issuer agrees to repay the bond in a certain amount of time at an agreed upon interest level. Understanding that dynamic is the first step to successfully investing in bonds.
The next step in learning about how bonds work and how they can be used to improve a financial portfolio is to review some key terms. Some of these terms may be familiar to investors who have experience with other types of investments. Others are specific to the bond market.
There are numerous ways to classify bonds. First, bonds may be classified by the type of entity that issued them. For example, corporate bonds are bonds issued by independent corporations. Municipal bonds are bonds issued by government entities at the state or local levels. Bonds issued by the United States federal government are referred to as Treasury bonds or Treasuries. Generally, the term Treasury bond is used to reference federally-issued bonds that take 10 or more years to mature. Treasury bonds that mature in more than one year but less than 10 years are commonly called Treasury notes. Treasury bonds that mature in less than a single year are typically called bills.
Bonds may also be described by the terms under which they are issued. For example, a zero-coupon bond does not pay out regular interest payments to bond holders. Instead, these bonds are sold at a price below face value. Bond holders receive nothing until the bond matures, at which time they receive the full face value of the bond. For example, an investor might buy a zero-coupon bond for $10,000. He or she receives no interest payments over time. However, when the bond matures, the investor receives a single, lump-sum payment for $25,000, which represents both the face value and accrued interest of the bond.
Additionally, bonds may be classified by the features or options they contain. Convertible bonds are an example of this. Convertible bonds contain an embedded option that allows the bond holder to convert his or her investment into stock at any time during the life of the bond, if desired. The most common type of bond classified this way is a bullet bond. Bullet bonds are bonds that intentionally do not contain any options or features.
In some cases, investors may buy bonds directly from the issuer. In these cases, the terms, costs and returns on those bonds will be fairly straightforward. For example, an investor might purchase a fixed-rate bond with a principle of $1,000 and an interest rate of five percent. If the bond has an annual coupon date, the investor can expect to receive $50, or 5 percent of $1,000 principle, each year over the life of the bond.
Investors who do not purchase bonds directly from the issuers may buy existing bonds from other investors via an exchange. The cost and ultimate values of bonds purchased in an exchange will fluctuate with market conditions. Key influencers of bond prices include interest rates, the issuers’ credit ratings and the duration of the bond.
Bonds with fixed interest rates become more desirable when market interest rates fall below the bond’s rate of return. They become less desirable when market rates rise above the bond’s rate of return. For example, a bond with a 10 percent interest rate will be highly desirable to other investors when the market interest rate sits at a lower amount like seven or eight percent. As a result, investors are often willing to pay more than the face value of the bond to acquire it. When market interest rates rise above a bond’s interest rate, however, the selling price of that bond will drop. Using the same example as above, if the market interest rate were to rise to 12 percent, the $1,000 face value bond might only sell for $900.
Bonds issued and due to be repaid by companies with strong credit ratings regularly command higher levels of demand than those issued by companies with poor credit ratings. This is because the lower a company’s credit rating, the higher the risk that it will be unable to repay the bond at its face value when it reaches maturity. The increased risk leads to these bonds typically being sold and purchased at prices well below face value.
The duration of the bond, or the time remaining before it reaches maturity, is considered a key influencer of bond value, as well. The longer a bond has before it matures, the more insulated it is from immediate market fluctuations. This makes longer-term bonds relatively stable and reliable investments, and therefore attractive to investors looking to balance the risk of their portfolios.