When you make a large purchase, like a house or an automobile, you often need to borrow money to balance your finances. Not everyone has a liquid $400,000 set aside for home ownership, but a more common scenario is a $80,000 down payment and a $320,000 loan from a bank. You get the house, the seller receives cash, and the bank receives an interest-earning asset.
Corporations and governments also sometimes need to borrow money for large capital expenditures, and they often do so by issuing bonds. Like a mortgage or car loan, bonds can be sold to investors and used in all kinds of portfolios. In this article, you’ll learn how bonds work, why investors seek them out, and what risks to be aware of when buying.
What Are Bonds?
A bond is a fixed-income investment representing a loan made by an investor to a borrower, usually a corporation or government. Like a loan, a bond typically has a fixed interest rate and a maturity date. The bondholder receives periodic interest payments, known as coupons, and the principal amount is repaid at the bond's maturity date. Bonds are used to raise funds for various projects and operations, offering investors relatively stable and predictable returns compared to stocks. Many institutions, including federal governments, municipal governments, mega-cap conglomerates and micro-cap startups issue bonds.
Imagine Fictional Company Z wants to raise money for a large project. The board could approve new stock issuance, which might be unpopular if it dilutes existing shareholders. They could also issue bonds, which don’t require relinquishing any equity but debt that must be repaid at a fixed future date. Company Z might choose the second option in this scenario and issue bonds to preserve shareholder equity.
Key Bond Terms
Before making an investment, you need to understand the fundamental terms associated with bonds.
Principal
Also referred to as Face Value or Par Value, the principal is the amount the issuer agrees to repay the bondholder at the end of the term. This differs from the bond's price, which can fluctuate based on several factors. If held to term, the bondholder will receive the total principal amount back regardless of the bond’s current market price.
Issuer
The entity that borrows the money by issuing the bond is called the issuer. This can be a government, municipality, or corporation.
Coupon Rate
Another way of saying interest rate, the coupon rate is fixed as an annual percentage of the bond’s principal. Coupons can be paid semiannually or annually, but the rate is always the principal divided by the annual interest received.
Maturity Date
Most bonds have a term after which the investor receives their principal back. This end date is known as the maturity date because the bond ‘matures’ and is retired by the issuer. Bonds can have short-term, medium-term, or long-term maturities.
A callable bond can be redeemed by the issuer before their maturity date at a specified call price, usually at a premium to the face value.
Yield
A bond’s yield is the amount investors can expect to earn from the asset based on market conditions. Yield differs from the fixed coupon rate because it fluctuates based on factors like interest rates and inflation. A bond’s yield has an inverse relationship to its price.
Credit Rating
Bonds aren’t a foolproof investment. If the issuer has financial difficulty, it may become unable to meet its obligations to bondholders. Because of this risk, credit agencies like Moody’s, Standard & Poor’s, and Fitch rate bonds based on the issuer's creditworthiness. Naturally, riskier bonds tend to come with higher yields.
Types of Bonds
All kinds of institutions can issue bonds, but the main types you’ll encounter as an investor include:
U.S. Treasuries
Treasuries are bonds issued by the U.S. federal government. They are named differently based on their duration: Treasury bills are 12 months or less, Treasury notes are one to nine years, and Treasury bonds are 10 to 30 years.
Municipal Bonds
Bonds issued by state, county, or city governments are known as municipal bonds, often called simply "munis." They are typically used to fund local projects like road construction or school funding and frequently offer tax breaks on investment gains.
Corporate Bonds
When a company issues debt to raise capital, it sells a corporate bond to investors. Corporate bonds are considered riskier than government bonds (primarily when issued by smaller companies) but often carry higher yields. Corporate bonds can be screened by company size, industry or sector, duration, and more.
Bonds issued by companies with lower credit ratings are known as high-yield or junk bond because they offer higher yields to compensate for the increased risk of default.
Convertible bonds are a type of corporate bond that can be converted into a predetermined number of shares of the issuing company's common stock. This conversion can typically be done at the bondholder's discretion and is usually defined by specific terms and conditions set at the time of issuance.
Agency Bonds
A mix between corporate and government bonds, an agency bond is issued by a government-sponsored enterprise like Fannie Mae or Freddie Mac. A common variety of agency bonds is mortgage-backed securities (MBS) which are securitized by individual mortgage payments.
Savings Bonds
Savings bonds are a type of bond issued by the federal government designed for individual investors to provide a safe and low-risk investment option. They offer tax advantages, such as deferral of federal taxes until redemption or maturity and exemption from state and local taxes. Savings bonds can typically be redeemed after a minimum holding period.
Zero-Coupon Bonds
Instead of coupon payments, zero-coupon bonds are issued at a significant discount to their face value and pay the full face value at maturity. The difference between the purchase price and the face value represents the interest earned by the bondholder. Zero-coupon bonds can be issued by various entities, including governments, municipalities, and corporations. These bonds tend to be more sensitive to changes in interest rates and are often used as long-term investments, providing a known return at a specific future date.
Why Invest in Bonds
If bonds usually have a lower expected return than stocks, why would investors favor them? The short answer is because not every investor seeks pure profit maximization.
Here are a few reasons to consider bonds:
- Stable Income: Bonds offer a level of predictability that assets like stocks or commodities cannot. If held to duration, a bondholder knows precisely how much interest they’ll earn and the principal they’ll receive when the bond matures. Even if you don’t hold until maturity, bonds provide consistent and stable income with minimal volatility.
- Lower Risk: Bonds tend to be less volatile than stocks. While they can fluctuate, bond prices often move more incrementally. Additionally, bondholder claims are ahead of stockholder claims in bankruptcy cases.
- Diversification: Bonds are often part of a diversified asset portfolio because they frequently move in the opposite direction of stocks. While inverse moves aren’t guaranteed, bonds and stocks diverge enough that investors use a combination of the two assets to assemble sturdy and diverse portfolios.
Risks Involved with Investing in Bonds
Low risk doesn’t mean that risk is entirely absent from a bond investment. Bond prices and yields fluctuate based on various factors, and holding them until maturity isn’t always an option. Here are five critical risks all bond investors should consider:
1. Interest Rate Risk
Bond prices can be volatile when interest rates move rapidly. For example, if interest rates rise, a previously issued bond may yield less than a newer one. In this scenario, the lower-yielding bond will be less attractive, and investors will demand a lower price compared to the newer bond with a higher rate. Long-duration bonds have more exposure to interest rate risk than short-duration ones.
2. Credit Risk
How solvent is the bond issuer? In the event of default, bondholders may lose money on their investment (if they receive anything at all). Companies with high default risk often have higher-yielding bonds since investors demand compensation for their exposure to a potentially troubled institution. Debt holders are higher up the chain than equity holders, but there’s no guarantee an insolvent company can repay its obligations.
3. Reinvestment Risk
Receiving steady annual coupon payments is a big benefit of bond ownership, but what if you can’t find other bonds with a similar rate and risk profile to reinvest in? This is known as reinvestment risk, which often occurs when interest rates are falling. For example, if you own a bond with a 6% coupon but can only find new bonds yielding 5%, you might be forced to take on more risk or accept a lower return. Double-risk whammy if your bond is callable; companies often recall their bonds with haste when interest rates drop
4. Inflation Risk
Bonds are considered fixed-income securities since coupon payments are usually permanent and the principal amount doesn’t change. However, fixed-income securities may struggle to keep up during periods of high inflation. Since inflation erodes purchasing power, bonds often fall out of favor for higher-yielding stocks during inflationary periods. Additionally, if you have a fixed income portfolio, your annual coupon payments could fail to meet your goals in high-inflation environments.
5. Liquidity Risk
Like stocks, bonds are issued by companies (or other institutions) and then bought and sold on an open market. And also like stocks, bonds can face liquidity crunches when one side heavily outweighs the other. If you need to raise cash and can’t find a buyer for an illiquid bond, you might be forced to accept less than the prevailing market price to facilitate the transaction.
Bonds are Safer than Stocks, but Not Without Risk
Bonds can help diversify a portfolio, but they can’t completely erase risk from the equation. Bonds are subject to interest rate changes and quickly rising inflation. Bond issuers can become financially fragile during economic downturns or when adverse regulatory changes are passed. At times, you simply may not be able to find a buyer willing to pay par value.
As of 2023, the global bond market is valued at approximately $140.7 trillion, reflecting a 5.9% increase from the previous year. This makes it larger than the global equities by $25.7 trillion. Bonds come with different yields, durations, and creditworthiness, creating a flexible asset class that can fit into the financial plan of most investors.
Always research the bonds you buy like you would a company stock and be sure to consult an investment advisor before making any significant purchases for your portfolio.
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