You've heard "stocks and bonds" since you were old enough to catch the news on TV with your folks. While figuring out stocks was easy (somewhat), you've never really mastered bonds. So I'm here to explain. Follow me: When large organizations need funds, they issue bonds. These include the national government, cities, and corporations. An individual bond is a piece of the loan. Since the size of the organization is large and it needs a huge amount of funds, they borrow money from more than one source. This way, they raise a significant amount of money from several people. Bonds are a fixed type of investment and an important asset class.
Still confused? OK, keep reading and I'll explain in more detail. By the end of the article, you'll finally know what bonds are.
How do bonds work?
Before you buy bonds, you must understand how they work. Whenever bonds are issued, the borrowing organization promises to pay the bond back at a specific date. Until then, the borrower will make agreed-upon interest payments to the holder of the bond. Those who own the bonds are known as creditors.
When the bond matures, the organization will pay the face value. However, it is possible to sell bonds before they mature and you can do this through the secondary market for bonds. They are publicly traded on the exchange and even sold in private between the creditor and the broker. The value of the bond will rise and fall until maturity and you can resell them any time you want.
Here's an example: Apple Inc. wants to borrow $10 billion from investors. The company believes that the market will let them set a coupon rate of 2.5% for a maturity date 10 years from the date of issue. Each bond will be issued at a par value of $1,000 and the interest will be paid semi-annually. Apple will approach investors who are keen on buying the bonds. Now, Apple needs to sell 10 million bonds at $1,000 to raise $10 billion. The bondholder will receive $25 a year in interest and it will be paid semi-annually so it will be $12.50 for 6 months. At the end of the 10 years, the $1,000 will be returned to the investor by the bond issuer and the bond will cease to exist.
Bonds are similar to stocks and can be purchased in mutual funds
. If you do not want to buy individual bonds, you can opt for the bond funds. Just like stocks, there is a bond mutual fund where experienced fund managers can pick the best selection of bonds. If you are not an experienced bond investor, you can opt for a bond fund that can also reduce the risk through diversification. If there is a default, you will lose only a small part of the money.
Types of bonds
You will find various types of bonds in the market. They vary based on the issuer, tenure, risk, and interest rate.
U.S. Treasury Bonds. If you are looking for the safest bonds, you should opt for the ones issued by the government. These are short-term U.S Treasury bills. However, with low risk comes low return so they will pay minimal interest. But there are also long-term Treasury bills that carry less risk and marginally higher yields.
Municipal Bonds. Municipal bonds are issued by localities or cities and they have a slightly higher rate of return than Treasuries but they are also a bit riskier. Municipal bonds are tax-free.
Savings Bonds. Issued by the Treasury Department, savings bonds are meant for individual investors. They are adjusted for inflation every 6 months.
Corporate Bonds. Bonds issued by companies are known as corporate bonds and they carry a higher risk than government bonds. Since companies cannot raise taxes to pay for the bonds, they will have a higher risk but they also offer higher returns. The rate of return depends on the creditworthiness of the company. The risk and return bonds are known as junk bonds or high-yield bonds. These bonds have a high default risk.
Zero-Coupon Bonds. Zero-coupon bonds are the type of bonds that do not distribute any interest income in the form of direct deposit of checks, instead, the bonds are issued at a discounted amount. It is meant to par and mature at the face value. The interest accrued in the holding period will be paid out at the time of maturity.
Agency Bonds. The bonds are issued by Quasi-governmental agencies like Freddie Mac who sell the bonds that are guaranteed by the federal government.
Callable bonds. Callable bonds are also known as redeemable bonds and can be redeemed before the maturity date.
Types of bond risk
An understanding of different types of bonds will help you make the right investment decision. Bonds are considered to be safe as compared to other investment products but they do carry some risk.
Credit Risk. This is the risk of not receiving the promised principal and interest on the guaranteed time because of the inability of the issuer to distribute it to you. This risk can be managed by sorting bonds into investment-grade bonds and junk bonds.
Inflation Risk. Inflation has become a part of our lives and there is always a chance that the government may enact policies that could lead to inflation. If you own a variable rate bond, you are protected, but if there is a fixed-rate bond, you will have to bear the risk of inflation. High inflation can destroy your purchasing power and by the time you receive the principal amount back, you would be paying a higher price for basic goods and services than you expected.
Liquidity Risk. Investing in bonds carries low liquidity. You can liquidate stocks immediately but with bonds, it does not work like that. Once you buy them, you may find it difficult to sell them at top dollar. It is best to buy bonds that you want to hold until maturity.
Price versus yield
A lot of people find valuing bonds extremely confusing. Many do not understand why the bond yields move inversely with the value of the bond. The more demand for the bonds, the lower the yield, and this seems counterintuitive to many. This happens because of the presence of the secondary market. With the demand for bonds, people will be willing to pay a higher price. However, the interest rate remains fixed so buyers who pay a higher price also receive the same amount of interest. Hence, the price paid for the bond will lead to a lower return and thus, a lower yield.
How to buy bonds
Purchasing bonds is not as easy as buying stocks, because of the initial amount you need to begin investing. In most cases, the face value of the bond is $1,000 but there is a way around that. Here are a few options to buy bonds:
From the broker. You can purchase bonds from an online broker like Stash or Fidelity and you will be buying from the investors who are looking to sell. It is also possible to get a discount on the face value of the bond by purchasing it directly from the underwriting investment bank at the time of initial offering.
From an exchange-traded fund. ETFs
purchase bonds from companies and they are focused on short-term, long-term, and medium-term bonds. They also give specific exposure to certain markets and industries. It is a great option for individual investors because it helps diversify and you will not have to buy in large increments. You can trade bonds via ETFs on Robinhood
From the government. There is a program on the Treasury Direct website set up by the federal government and it allows you to buy bonds directly without having to pay a fee to the broker.
Things to look for when buying bonds
It is a tricky process to buy bonds, especially if you are buying used bonds or not buying directly from the underwriter. Keep these things in mind when you buy bonds.
Credit rating. One of the most important factors to keep in mind is the credit rating. It shows whether the company can pay its bonds. Look at the credit rating issued by rating agencies. The safest will be Treasury Bonds who usually have an AAA.
Tenure. The duration of the bond is the period that shows how long the investor will take to recover the price of a bond, keeping the present value of its future interest payments and repayment of principal in mind. The duration indicates how sensitive the bond will be towards a change in interest rate. When the tenure is longer, it will transfer to high fluctuation when the interest rates change so when the interest rates rise, the bond value will fall. If you want the full bond payout and want the set interest rate, hold them until the maturity date.
Cost. Be aware of the fees that the brokerage will charge on the cost of the bond. Sometimes, the fees can be high. You need to ensure you are getting a fair deal by taking a look at the publicly available data on the pricing of the bond you are looking to buy.
Pros and cons
- Interest income. When you invest in bonds, you receive regular income in the form of interest payments. If you hold the bond until maturity, you will also get the principal amount back. Bonds are very safe and you will never lose the investment unless the entity defaults.
- Profit on sale. You can resell the bonds anytime you want to. If the bonds sell at a higher rate than you bought them, you will make a profit. Some traders bid up the price beyond its face value and it can help generate high profits.
- Low rate of return. If you compare bonds with other investment products, you will notice that the rate of return is lower in the long term. Since the risk is low, the return is also low. In this case, it may not be possible to earn enough to outpace inflation. If your goal is to save for retirement, investing only in bonds may not be enough.
- Default risk. Some companies also default on bonds due to which you could end up losing all your money. They offer higher interest rates to lure buyers and quickly default. Hence, always check the S&P ratings of the bond issuer before you purchase.
Stocks vs. bonds
A lot of investors are confused about whether they should invest in stocks or bonds. It is important to understand that both are very different investment products and serve different needs. Let’s take a look at the differences in detail.
Ownership vs. debt
Equity is about investing in the stock market. It is a popular liquid financial asset that provides ownership in the company. You can trade the stocks in the stock market and enjoy instant liquidity. When corporations issue equity to raise cash, you have an opportunity to make the most of the growth and success of the company. However, when you buy bonds, you do not get ownership in any company but you enter into an agreement with the issuing company to receive fixed interest over time and the principal amount at the end of the tenure.
Fixed income vs. capital gains
Bonds and stocks generate income in different ways. With stocks, you will need to sell the company’s shares at a higher price than you bought them for and you can generate profit whereas bonds can generate fixed income for you in the form of interest.
When the price of stocks rises, the prices of bonds fall and vice versa. This is how they work. When the stock prices are increasing, more people are willing to capitalize on the growth, and bond prices will decline due to lower demand. Conversely, when the price of stocks is falling, investors are on the lookout for low-risk options like bonds and as their demand increases, the price also increases.
Are bonds right for you?
Let’s take a look at the factors to consider when deciding if bonds are right for you.
What tenure are you looking for? You must check the term of the bond before buying. There are bonds with 5 years and 10 years or even more. It helps to decide when you will need the money. If you think you will need the money before the bond term is up, it will not be ideal to invest in bonds.
What is your risk appetite? Bonds are less risky as compared to other investment options. But you still need to check the bond’s rating before you purchase. The rating will help decide the creditworthiness of the bond. When a bond has an AAA rating, it is the highest rating and if it is below C, it is a junk bond with high risk.
The bottom line
Whenever you invest in bonds, you give your money to an organization that needs funds. You will earn regular interest income in exchange for the money. Bonds are considered less risky than stocks but also generate low returns. If you have a low-risk appetite and are looking for a safe place to park your money, opt for bonds. You can also earn a profit if you sell the bond at a higher price.
It is recommended to invest a portion of your money into bonds because of low risk and relative safety as compared with stocks. Find the right bonds at the right time and diversify your portfolio.