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4 Basic Things to Know About Bonds

Looking to improve your portfolio’s risk and return? Bonds can help balance your portfolio, adding diversity and reducing…
4 Basic Things To Know About Bonds

Looking to improve your portfolio’s risk and return? Bonds can help balance your portfolio, adding diversity and reducing volatility. But if you’re new to bonds, don’t worry – even seasoned investors can find the bond market tricky.

Many investors shy away from bonds because the bond market terminology is confusing. But really, bonds are just simple loans. So, how can you dip your toes into this market? Start by getting familiar with these basic bond terms.

KEY TAKEAWAYS

  • Investors can spread their investments beyond stocks by exploring the bond market.
  • Bonds have different features, like when they mature, the interest rate they pay (called coupon rate), how they’re taxed, and how easy they are to buy or sell (scalability).
  • Bonds come with risks related to changes in interest rates, the possibility of the issuer defaulting on payments (credit risk), and the risk of early repayment (prepayment risk).
  • Many bonds have ratings that indicate their investment grade.

Basic Bond Characteristics

A bond is like a loan a company gets from investors instead of a bank. Investors buy the company’s bonds and, in return, pay them interest, known as the interest coupon. This interest is paid annually or semiannually. When the bond matures, the company returns the principal amount, ending the loan.

Unlike stocks, bonds can differ depending on the terms outlined in their legal document, which is called indenture. Each bond has unique features, so it’s crucial to understand them before investing. There are six key aspects to consider when evaluating a bond.

Important: Bonds are like a promise between the lender and the borrower.

Types of Bonds

Corporate Bonds

Corporate bonds are loans that companies take out to cover costs and get money. How much you earn from these bonds depends on how trustworthy the company is. The riskiest ones are called “junk bonds,” but they can also give you the most money back. The government taxes the interest you get from corporate bonds.

Sovereign Bonds

Sovereign or government bonds are loans countries take out to cover costs. Since countries are unlikely to repay their debts, these bonds usually have a high credit rating and offer lower returns. In the US, government bonds are called Treasuries; in the UK, they’re called gilts. States or local governments do not tax treasuries but are still taxed by the federal government.

Municipal Bonds

Municipal bonds, also called munis, are issued by local governments, including states and counties, not just cities. Income from municipal bonds is usually not taxed, making them appealing to investors in higher tax brackets.

Tip: Discover Investopedia’s 10 Rules of Investing by grabbing a copy of our special print edition.

Key Terms

Maturity

This is when the company pays back the bond’s principal amount to investors, and the bond’s obligation is finished. It marks the end of the bond’s life. A bond’s maturity is a key factor investors consider when considering their investment goals and timeline. Maturity is usually categorized in three different ways.

  • Short-term: Bonds in this group typically mature within one to three years.
  • Medium-term: These bonds usually mature four to ten years from issuance.
  • Long-term: These bonds typically mature more than ten years from being issued.

Secured/Unsecured

A secured bond is backed by specific assets that the company promises to give to bondholders if it can’t pay back the loan. This asset, also known as collateral, acts as security for the bond. If the company fails to repay the bond, the asset is given to the investor. For example, a mortgage-backed security (MBS) is a secured bond backed by the titles to borrowers’ homes.

Unsecured bonds, also known as debentures, don’t have any collateral backing them up. This means that if the company can’t pay back the bond, investors might not get much or any of their investment back. Because they’re riskier, unsecured bonds usually offer higher interest rates to attract investors.

Liquidation Preference

When a company goes bankrupt and sells its assets, it has a specific order for repaying investors. First, it pays back senior debt holders, then junior (subordinated) debt holders, and finally, whatever is left goes to stockholders.

Coupon

The coupon amount is the interest paid to bondholders, usually once or twice a year. It’s also known as the coupon rate or nominal yield. Divide the yearly payments by the bond’s face value to find the coupon rate.

Tax Status

Most corporate bonds are subject to taxes, but some government and municipal bonds are tax-exempt, meaning you don’t pay taxes on the income and gains. Tax-exempt bonds usually offer lower interest rates than taxable ones. Investors need to calculate the tax-equivalent yield to compare returns with taxable bonds.

Callability

The issuer can pay back certain bonds before they reach maturity. This happens if the bond has a call provision, which allows the issuer to pay it off early, usually at a slightly higher price. Companies may do this when they can get a lower interest rate elsewhere. Callable bonds can attract investors because they often come with higher coupon rates.

Risks of Bonds

Bonds are a good way to make money because they’re usually safe investments. However, like all investments, they have risks. Here are some of the most common ones.

Interest Rate Risk

When interest rates go up, the value of bonds usually goes down, and bond values tend to go up when rates go down. This is called interest rate risk. If rates change more than expected, it can affect how much money you make. If rates drop a lot, you might get paid back early. If rates increase, you might be stuck with a bond that pays less than newer ones. The longer you have until your bond matures, the riskier it is because it’s harder to predict what rates will do over a longer time.

Credit/Default Risk

Credit or default risk is the chance that a company or government will not repay the money it owes on a bond. When you buy a bond, you expect to get your interest and the money you invested back, but sometimes, the issuer might not be able to pay as promised. This risk is similar to when someone borrows money and can’t repay it.

When considering corporate bonds, investors need to consider the chance that the company might be unable to repay the borrowed money. Safety comes from companies having more money than the debt they owe. If a company owes more money than it can handle, investors might want to avoid investing in its bonds.

Prepayment Risk

Prepayment risk occurs when a bond is paid off earlier than expected, usually because of a call provision. This can be a problem for investors because companies usually pay off bonds early only when interest rates have dropped significantly. Instead of keeping a high-interest investment, investors have less money to invest at lower interest rates.

Bond Ratings

Bonds often have a rating that shows how reliable they are in paying back the money they owe. This rating helps investors decide whether the bond is a good investment.

Agencies

Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings are the main bond rating agencies. They assess how likely a company is to pay back what it owes. Each agency has its rating scale. For S&P, the safest bonds are rated AAA to BBB. These low-risk bonds are unlikely to default, making them stable investments.

Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings are the main bond rating agencies. They assess how likely a company is to pay back what it owes. Each agency has its rating scale. For S&P, the safest bonds are rated AAA to BBB. These low-risk bonds are unlikely to default, making them stable investments.

Some companies may not have their bonds rated, so it’s the investor’s responsibility to assess the company’s ability to repay. Ratings can vary between agencies and change over time, so research the specific rating definitions for the bond you’re interested in.

Bond Yields

Bond yields are different ways to measure how much money you can make from a bond. The most common one is called “yield to maturity,” but there are other ways to measure it. Understanding these different measurements is important in certain situations.

Yield to Maturity (YTM)

Yield to maturity (YTM) is the most commonly used way to measure how much money you can make from a bond if you keep it until it matures and reinvest all the interest payments at the same rate. However, it’s unlikely that you’ll reinvest the interest at the same rate, so your actual return might be a bit different. Calculating YTM by hand can be complicated, so it’s easier to use functions like RATE or YIELDMAT in Excel or a financial calculator to figure it out.

Current Yield

The current yield helps you compare the interest from a bond to the dividends you’ll get from a stock. Divide the bond’s yearly interest by its current price to figure it out. But remember, this only shows the income part of what you’ll get, not any gains or losses in value. So, it’s best for investors who care mainly about income.

Nominal Yield

The nominal yield on a bond is just the percentage of interest it pays periodically. You find it by dividing the yearly coupon payment by the bond’s face value. But it’s not a reliable measure of return unless the bond’s current price equals its face value. So, we mainly use nominal yield to calculate returns in other ways.

Yield to Call (YTC)

A callable bond can be paid off before its maturity date, which means there’s a chance it might get called early. If that happens and the bond gets paid off at a higher price, investors could earn a slightly higher yield. Investors want to know what yield they’ll get if the bond is called on a specific date to decide if the risk of early payment is worth it. You can easily determine this yield using Excel’s YIELD, IRR functions, or a financial calculator.

Realized Yield

An investor must calculate the realized yield to sell a bond before it matures. This involves estimating the bond’s future selling price, which can be tricky because future prices are uncertain. This calculation gives an estimate of the return. You can determine this yield using Excel’s YIELD, IRR functions, or a financial calculator.

How Bonds Pay Interest

Bondholders receive payments for their investments in two ways. First, they receive periodic interest coupon payments throughout the bond’s lifetime. These payments continue until the bond reaches its maturity date when it can be redeemed for its full face value.

Zero coupon bonds are different from regular bonds because they don’t pay any interest during their lifetime. Instead, investors only receive the face value of the bond when it matures. These bonds are typically sold at a lower price than their face value, and the difference between the purchase price and the face value is considered the interest earned on the bond.

Convertible bonds are unique investments that combine the features of bonds and stocks. They start as regular bonds that pay a fixed interest rate. However, they also allow investors to convert them into shares of the issuing company’s stock. This means investors can potentially benefit from any significant increase in the company’s stock price.

FAQs

1. Which Is Larger, the Stock Market or the Bond Market?

Ans: The bond market is bigger than the stock market in terms of overall market value.

2. What Is the Relationship Between a Bond’s Price and Interest Rates?

Ans: When interest rates rise, bond prices typically fall, and when interest rates fall, bond prices usually rise. It’s like a seesaw effect between bond prices and interest rates.

3. Are Bonds Risky Investments?

Ans: Bonds are typically considered safer and less risky than stocks but still carry risks. One risk is credit risk, which means the issuer might be unable to repay the bond. Another risk is interest rate risk, meaning bond prices can drop if interest rates increase.

The Bottom Line

While the bond market may seem complicated, it’s driven by risk and return factors similar to the stock market. Once investors understand key terms and measurements, they can understand how the market works and become skilled bond investors. Once you’re familiar with the language, the rest becomes straightforward.

Correction—Jan. 18, 2024: This article clarifies that medium-term bonds usually mature within four to ten years.

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