How do bonds work?
We hear “stocks and bonds” over and over again when people talk about investing. But what exactly is a bond? How do bonds work? Do we want to be investing in them?
Understanding the basics of bonds and how they work is an important part of becoming a savvy investor so we can make the best decisions for our money.
Here’s the rundown on what a bond is, how they work, and everything else you need to know about bonds.
What’s a bond?
When we buy a bond, we’re lending someone money - usually a company or government. In return, we get our money back plus interest. There is an agreed upon interest rate, which is why a bond is also called a fixed income investment (we get back a fixed amount).
How do bonds work?
Just like we borrow money to buy things like homes and cars or to go to college, corporations and governments need loans, too. This might be to expand the business or fund a specific project.
Because companies are looking to borrow large amounts of money - often much larger than a bank can provide - they go to the open market. They can issue (aka sell) shares of stock or bonds to raise money. And anyone who wants to can buy them.
Here’s an example to show you how bonds work.
Philanthro-Pets is a successful social animal merchandise company (fun fact: this is a fictional company but I did start a company by the same name in college). They’ve grown quickly and have made some wonderful profits. They are based primarily in the United States and want to make a big push into South America. To do that, they’ll need $50 million for personnel, marketing, and manufacturing.
They weigh their options and decide to borrow the $50 million by issuing bonds. They decide to issue bonds with a par value of $1,000 at a 5% interest rate (called a coupon rate). The due date of the loan (called the maturity date) is ten years from now. In order to borrow $50 million at a $1,000 per bond, they’ll need to sell 50,000. They work with an investment bank to help them sell bonds to investors.
Whoever owns a bond earns $50 per year in interest (5% of $1,000) from Philanthro-Pets until the time of maturity. If all goes to plan, after 10 years Philanthro-Pets will pay investors back their $1,000 back.
Philanthro-Pets makes on-time payments and pays all of their bondholders back, but this isn’t always the case. If companies are unable to make their interest payments or pay back the principal (the amount they borrowed), the bond goes into default.
In the case of a default, bondholders don’t necessarily lose all of their money. The company (the bond issuer) will liquidate its assets and distribute them to various creditors (places it owes money). There are many factors that determine how much money bondholders will recover including how much in assets the company has to distribute and where that specific bond falls on the hierarchy of being paid back.
What’s the difference between a stock and a bond?
Stocks and bonds are very different. When we own a share of stock, we have an ownership stake in a company (albeit a very small one). By owning stock, we make money two ways. The first - if a company shares in its profits by way of dividends. And the second - if we sell our share for more than we bought them for.
When we own a bond, we’re essentially lending someone money (usually a government or corporation). We own the loan, not a part of the company. We make money via the interest payments or if we buy and sell the bonds at a premium to someone else before the due date or maturity.
Bond terms to know.
Investing jargon can be really intimidating, but it’s really just a new language that takes time to understand and get comfortable with. If you started talking to me in French, I wouldn’t understand We can understand a lot by learning the vocab.
Here are the most important bond terms to know:
Coupon
This is the interest rate that the borrower pays to the bondholders. The coupon rate doesn’t change over the course of the life of the bond. In the Philanthro-Pets example, the coupon rate was 5%.
Face Value (or Par Value)
Face Value (also called Par Value) is the value of the bond when it was issued. In the Philanthro-Pets example, the face value (or par value) of the bond was $1,000. $1,000 is the most common par value.
Price
When a company sells or issues a bond, it’s priced at the face value amount. In the Philanthro-Pets example, that would be $1,000. Buying a bond from Philantrho-Pets would cost $1,000.
Investors can buy and sell those bonds on the secondary market at whatever price people will pay for it. The current amount that a bond is being traded for is its current price.
Yield
Since the price of a bond fluctuates, the coupon rate changes. For example, if I buy a Philanthro-Pets bond on the secondary market for $900 (when it’s par value was $1,000), the coupon rate is no longer 5%. I’d be receiving $50 each year in interest payments from Philanthro-Pets on a $900 investment, which is a 5.6% interest rate. The yield is the interest rate of the bond that takes into account the fluctuating price.
Maturity
The maturity is the term of the loan, or how long it takes for the investor to get the face value of the bond back. In the case of the Philanthro-Pets bond, the maturity was ten years.
The relationship between bonds and interest rates.
There’s an inverse relationship between bond prices and interest rates. That means when interest rates go down, bond prices go up and vice versa.
Imagine you own one Philanthro-Pets bond that you purchased for $1,000 with a coupon rate of 5%. Let’s pretend the current price and yield are the same. If interest rates decrease to 4%, meaning similar bonds are offering 4% interest, the value of your Philanthro-Pets bond will go up. The Philanthro-Pet bonds become more valuable because they are offering a higher interest rate the current market.
Original: 5% (coupon rate) x $1,000 par value = $50 (coupon payment)
Current: 4% (market rate) x $1,250 (new market price) = $50 (coupon payment)
As we now know, the current price will move until the yield (or interest rate on the bond) reflects current interest rates.
Types of bonds.
There are a bunch of different types of bonds. Here are some of the most common and important categories.
US Treasuries
US treasuries are bonds issued by the US government. Maturities range from days to thirty years. Since the borrower is the US government, they’re considered very safe investments. We expect the US government to make on-time interest payments and pay back what it owes. US treasuries with maturities of less than one year are called treasuries, those with maturities of one to ten years are called T-bills, and those with maturities of ten years and longer are treasury bonds.
Government Bonds
Much like the US government, other governments issue bonds as well. They issue bonds to fund various programs and pay their employees. Bonds from governments like the US are considered to be very stable and safe, while those from other countries with less stable governments are considered to be more risky.
Municipal Bonds
Municipal bonds, also called “muni bonds” are bonds issued by counties, states, and other municipalities. They issue bonds when they need more money than they are earning in taxes to fund things like hospitals, airports, and bridges. Investors in muni bonds don’t have to pay federal taxes on interest payments.
Corporate Bonds
Corporate bonds are issued by companies like in our Philanthro-Pets example. These are typically considered riskier than government bonds and therefore often earn a higher interest rate.
Rating agencies like Standard & Poors and Moody’s provide credit ratings on corporate bonds for investors to understand the risk of default. High yield bonds are corporate bonds that have a lower credit rating, so the interest rate (or yield) is higher.
What are the risks of investing in bonds?
It’s important to understand the various risks of investing in bonds so that we can make educated decisions as investors. Here are the biggest risks to consider.
Interest Rate Risk
When you invest in bonds, there’s the risk that interest rates will rise. As we talked about above, there is an inverse correlation between interest rates and bond prices. If interest rates go up, the price of our bonds will go down.
Liquidity Risk
Depending on what types of bonds you invest in, it might be difficult to trade them on the secondary market. If you’re unable to sell your bonds, you will have to wait until maturity to get your money bank, or you can sell them for a discount to get investors interested. This is important to account for if you plan to invest in less liquid bonds. You’d want to use funds you won’t need until after the bond maturity date.
Reinvestment Risk
Reinvestment risk is related to interest rates. If interest rates happen to be low when our bond matures and we’re ready to invest again, we may have missed out on investing in a higher interest rate market. It’s all about timing!
Credit Risk / Default Risk
Credit risk is the risk that the company or government that issued the bond won’t be able to make interest payments or pay back what it owes to borrowers. As the bondholder, credit risk is the risk that you won’t receive your owed principal and interest.
This is the risk that the bond issuer will go into default. Credit agencies rate bonds in order to give us a better idea of how likely it is for them to default. Typically, the higher the credit risk, the higher the interest rate is in order to compensate investors for taking on more risk.
What’s a bond fund?
If you want to own bonds but aren’t interested in investing in individual bonds, a bond fund can be a great option. Just like a stock fund, a bond fund is a pooled investment that has an investment directive.
Some bond funds invest in the total bond market, and others invest in more specific areas. There are bond funds just for munis, governments, and even corporate bonds with specific credit ratings.
Bond funds are a great way to diversify your investments (i.e. not put all of your investment eggs in one basket) when you aren’t working with a larger amount of money. With one share of a bond fund, you could own hundreds or thousands of different bonds.
Why invest in bonds?
Bonds, whether on their own or via a bond fund, are often an important part of our portfolios. Bonds aren’t investments for growth, like stocks, but rather, typically offset some of the volatility of our stock investments.
By owning a bond, we own a piece of debt and not a part of a company (like we do with owning stock). The upside of a bond is fixed as we know what we can expect to earn on our investment via the coupon payments and return of principal. This is why you’ll hear bonds called “fixed income” investments.
Investing in stocks, on the other hand, is an ownership stake in a company. We earn money by selling our shares for a higher price than we bought them and also through company dividends where companies share part of their profit with investors.
Bonds can also provide a nice income stream via the interest payments.
When we’re young, we want our retirement portfolio to prioritize growth and will have only a small percentage invested in bonds. Over time, as we get closer and closer to retirement, the percentage of bonds will increase.
How to invest in bonds
You can buy individual bonds through the US treasury website or via your brokerage company (where you have your investment accounts). You can buy bond funds through your brokerage company as well.
In Conclusion
When we buy a bond, we’re lending someone (usually a government or corporation) money in exchange for interest and return of our loan. Bonds can be a great investment to reduce volatility and provide regular income through the interest payments. We can buy individual bonds for a specific company or government, or we can invest in bond funds for easy diversification.