Bonds

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.

Key Terms

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.

• Principle is the amount of money the investor pays for a bond. It can also be thought of as the amount of money the investor is loaning the company or government agency that is issuing the bond.

• The maturity date of a bond is the date on which the bond ends. By that date, the issuer must pay back the full principle of the bond. This fulfills the terms of the loan. Once the maturity date is reached and the principle is repaid, interest payments on the bond cease.
• A bond’s interest rate is the amount of money an issuer pays the bond holder for use of his or her money. It is usually expressed as a percentage. Bond interest rates may also be referred to as coupon rates.
• Fixed income securities are investments in which investors receive regular and consistent interest or benefit payments over a pre-determined amount of time. Investors know at the beginning of a fixed income security investment exactly what they will receive in return and when.
• Exchanges are centralized places, either physical or digital, where investors can buy bonds from sell bonds to other investors. Exchanges may be public, such as the New York Stock Exchange (NYSE), or private. Private exchanges are often called over-the-counter exchanges.
• The issue price – also called the par or face value -of a bond is the amount of money it is initially purchased for. It is the same as the bond’s principle and the amount of the money the bond holder will receive when the bond reaches its maturity date. Bonds are most commonly issued with pars of $100 or $1,000.
• The coupon date of a bond describes when and how often bond holders will receive interest payments.

Types of Bonds

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.

Buying and Selling Bonds

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.