In my previous blog Stocks 101, I hopefully demystified stocks. It’s time to follow up on that topic with the most natural next step – the breakdown of bonds.
Most of us have heard about bonds. Furthermore, most understand bonds are an investment vehicle much like stocks. However, I find many truly don’t understand how a bond operates. For instance, did you know the rarely talked about bond market is substantially larger than the stock market? It’s true; it’s about 30 trillion dollars larger! The global bond market is approximately $108 trillion compared to the approximately $79 trillion of the global stock market.
Generally, most understand that bonds typically carry less risk (when compared to stocks). They also have a lower expected rate of return over the long term. The global bond market makes up a large part of the world economy and is important to an investor’s portfolio. Because of those facts, I’ll take a few moments to describe what a bond is and how it works.
What is a bond?
While a stock represents shares of ownership in a company, a bond is actually the company’s debt. Therefore, when you purchase bonds, you’re actually lending your money to a publicly traded company. You, in essence, become a lien holder against that company and its assets. Think of it like a bank holding your mortgage. Instead; however, you as an investor are the “bank.” In most cases, the company will pay the investor a coupon payment (such as interest payments) semi-annually, then ultimately returns the principal amount at maturity.
Bonds are issued in different maturities, or lengths of time. They range from very short periods (days or months) up to about 30 years. Bonds also have an interest rate associated with them which compensates the investor for lending the money. Here’s a real life example:
Apple issues a bond at the nominal value of $1,000, with a maturity of 10 years at 4% interest. If you purchased the bond at issue, you’ll receive $40/year (or $20/semi-annually) in coupon payments. At the end of the 10-year term, Apple will pay you back the $1,000, along with the final coupon payment.
How are bond values determined?
Over the life of a bond, there are several variables affecting the price and value. At issue, the bond has a stated interest rate (4% in the Apple example). This rate may be different than the interest rate in the open market. Additionally, the company will have a credit rating designed to give investors a general idea of the company’s credit “worthiness.” Over time, the bond’s value will change as interest rates and perceptions of the company’s credit worthiness change.
Some more details on the variables influencing these factors are as follows:
- The Rating – Credit analysts give each bond a score based on the perceived ability of the company to repay the loan. A highly rated and financially strong company (like Apple) would likely be given a high AA/AAA rating. A company with inner turmoil; however, would be given a junk bond rating of C or D. The two biggest bond rating companies are Moody’s and S&P/Fitch. Naturally, the lower the rating upon initial issue, the higher the interest rate must be to entice you to lend your money to them. This is the only way these companies can get you to choose their bond over an equal bond of a higher rated company.
- Bond Maturity – Another key component in a bond’s value, both at issue and after, is its maturity or term. This is exactly like a CD. The longer you let the bank hold your money (so they can make more elsewhere), the better rate they’ll give you. This also gives them a longer period to refresh the funds for repayment. The longer the maturity on a bond (say 30 years versus 2 years) does mean more uncertainty for an investor. Changes in these variables can negatively affect the company’s ability to repay the debt.
- Federal Reserve Interest Rates – If you recall my blog on interest rates, the main entity responsible for setting interest rates is the Federal Reserve. When they adjust short term rates, those changes ripple through the credit markets. Investors want to be compensated for taking on additional credit risk and the longer lending periods. Thus, if interest rates are rising, you’ll see new bonds issued at higher rates over existing bonds. If you own a bond and interest rates rise or fall with the Federal Reserve short-term rate, you’ll typically see the price of the bond move inversely.
Example: You own that same $1,000 Apple bond at 4% and the Federal Reserve increases interest rates to a point where new Apple bonds with the same maturity are issued at 6%. It’s only natural that your bond is now worth less, because an investor can go purchase a new bond with a higher rate. The same holds true if rates were to fall, which would lead to your bond appreciating in value. This is why you often hear bond prices are inversely related to interest rates.
Why do companies issue bonds in the first place?
Why does a company issue a bond to investors? Would it not be simpler to borrow the money from a bank? The simple answer is: it’s cheaper.
Given that these corporations are universally worried about their bottom line, saving money is an attractive option. Additionally, banks tend to restrict the use of the funds or the company’s ability to issue more debt prior to the loan repayment. The cost and flexibility with issuing bonds is much more attractive than searching out a bank loan.
Over the past decade, we’ve seen historically low interest rates. Therefore, we’ve seen a rise in companies issuing bonds. What they’re doing is refinancing old, higher debt with lower-cost debt. They are also accumulating cheap cash to reinvest in growth and infrastructure.
Where can you trade bonds?
Unlike the stock market exchange, bonds don’t really trade on their own central exchange. The biggest challenge with bonds is the scale of the market; there are thousands of bond issuers, many with different maturities. Unlike perpetual stocks, bonds have a finite life. Eventually, they come to maturity. Once issued, it’s not common for bonds to trade.
But, they do get traded from time to time. Most bonds are traded Over-the-Counter (OTC) directly between two entities. Rather than an exchange (which is constantly trading and updating prices), bonds are more of a one-on-one transaction. Financial advisors, bond brokers, and/or online brokerage houses can facilitate this OTC transaction to help make it easier for the investor. However, bonds are generally less liquid due to a less vibrant trading marketplace. This is why most people invest through mutual funds, which both and help increase the liquidity of these investments.
What are the types of bonds?
Bonds typically fall into types, rather than sectors, and are based off who is issuing them and how they work. Understanding all the different types of bonds alone could be a full college semester. Therefore, I’ll keep it generic and brief to help underline the basics of the major types.
- Corporate Bonds – These are bonds issued by corporations, which usually pay higher coupon payments than their government counterparts. They fall into investment-grade bonds (rated BBB or better) or high yield bonds (rated BB or lower). High yield bonds typically have a higher interest payment due to the increased credit risk.
- Treasury Bonds – These are bonds issued by the US government and are considered “credit-risk free.” These are typically the safest and lowest yielding bonds on the market as they have the full backing of the United States Government. Although still subject to federal taxation, they have some tax favorability as they are exempt from local and state taxes on their payment coupons.
- Agency Bonds – These are bonds issued by government agencies (such as Fannie Mae) and have no special tax benefits. They are considered low on the risk spectrum, even if not fully backed by the US government. You’ll generally see these pay slightly higher rates than their Treasury counterparts.
- Municipal Bonds – Many of us have heard the term “munis.” These are bonds issued by local or state municipalities. Their interest rates vary significantly, generally based on the financial strength of each municipality. Their major benefit is they are exempt from both federal and state tax (assuming you live in the state where it’s issued).
- Other Bonds – I’ll reserve this for everything else. This can mean asset-backed bonds (mortgages, credit card, car loan I.E. securities backed by pools of loans), floating-rate bonds (the coupon adjusts with interest rates), inflation-linked bonds (coupon is tied to inflation), and convertible bonds (can be converted to a pre-determined shares of stock).
Any final thoughts on Bonds?
I’ll sum up by saying, bonds are typically less volatile and carry less risk than stocks. Don’t get me wrong though, they still have inherent risks that must be considered:
- Credit Risk: The inability to repay the loan.
- Interest Rate Risk: If rates rise, then the bond loses value.
- Liquidity Risk: The inability to convert the bond easily to cash.
- Inflation Risk: The chance that the bond will not be worth more in the future.
- Call Risk: The issuer has the ability to call back the bond if rates decrease.
Don’t let that list frighten you away. Bonds can be great components in a carefully constructed and diversified investment portfolio. They generate income and help hedge the risk of stock investing. That’s a powerful tool to utilize! Without proper understanding and guidance; however, you may find yourself in a less favorable position. That’s why understanding is truly key (especially when you have a coach – like me and my partners– on the sidelines pointing the way).
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