Bond: Introduction

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introduction to bonds

What is a Bond?

A bond is a debt instrument issued by a company that needs financial funding from investors. To obtain this funding they issue bonds, which are essentially IOU’s, then use the money for business operations.

A bond is a fixed income security – meaning investors get a fixed interest payment at regular intervals (annual, semi-annual, monthly, etc.).  When investing in bonds you essentially lend your money to a company that needs it, and in return you receive interest payments and your initial investment back once the bond reaches its maturity date.

Lets go over a few important terms before continuing:

  • Par Value – this is the value of the bond, also called face value, and is usually in $1,000 increments, but can be more.  This is the dollar amount you will receive once the bond matures.  The price you pay for the bond may differ from its par value depending on current market interest rates but the par value never does.
  • Coupon Rate – this is the interest rate your bond carries or the income you receive from lending your money to the company.
  • Maturity Date – this is the date the bond matures and the par value is paid back to the bondholder, along with any coupon payments.

How Can Investing in Bonds Help Your Portfolio?

By having bonds in your portfolio, you can increase your portfolio return when the stock market is low. So if the stock market is experiencing negative returns, the positive return from your bonds will off set your losses.

Why don’t bonds decrease when the market is low?  Because, as I mentioned before, they are fixed income securities and are obligated to pay the coupon rate at regular intervals and face value upon maturity date. This is why it’s important for people getting closer to retirement to have more bonds in their portfolio compared to stocks.

Investing in bonds does carry some risk. Default risk is the chance of the company defaulting on its debt or not being able to pay their investors money back. In this scenario a company goes bankrupt and has to liquidate their assets to pay back as much as they can to investors. Companies that are more risky will often have higher coupon rates compared to safer companies.

How Do You Know How Safe a Bond Is?

Investment firms rate how risky a particular bond is. Here’s how two popular rating agencies, Moody’s and Standard and Poor’s, rate bonds:

Quality/Risk Moody’s Standard and Poor’s

Highest Quality

Aaa

AAA
Aa AA
A A
Bbb BBB
Bb BB
B B
Ccc CCC
Cc CC

Lowest Quality

C C

Buying and Selling Bonds

You can buy and sell bonds at par (face value), a premium, or a discount in the secondary market.  Securities are sold in the primary market first, this happens when a large investment firm buys huge amounts of stock from the company. Then we (small investors) have a chance to buy them in the secondary markets (NYSE, NASDAQ, etc.). The current market interest rate will determine if you buy bonds at par, a discount, or a premium.

If the current market interest rate is the same as the bond’s interest rate (coupon rate), the bond will sell at par (or it’s face value) – So if the par value is $1,000, the bond will sell for that price.  If the market interest rate is less then the bond’s coupon rate, the bond will sell at a premium – more than $1,000. And, if the market interest rate is more then the bond’s coupon rate, the bond will sell at a discount – less than $1,000. The price of the bond is the only thing that changes, the interest rate and maturity date are specific to each bond and never change.

Why Do Bonds Change In Price?

You can think of this as if the bond price is equalizing itself out to match the current market interest rate, since bonds are actively traded. No one wants to buy a bond that has low returns when the market is experiencing high returns unless they can get the bond at a discount. And, everyone wants to buy bonds with high returns when the market is experiencing low returns, so they will have to pay a premium. So if you buy a bond at a premium, you pay more for it because the coupon rate (the income you make) is higher then the current market interest rates. If you hold the bond to maturity you will receive the par value. This is less than what you paid for the bond because you bought it at a premium, but your loss is offset by higher coupon payments you received while owning it.

Types of Bonds

  • Government Issued Securities – These include Treasury bills (T-bills), Treasury Notes, and Treasury Bonds. All of these investments are fixed income securities issued by the United States government. Because the government issues them, these securities are considered risk free and are backed by the full faith and credit of the government. For this reason their returns are also lower.
  • Municipal Bonds – Issued by state and local government agencies. Municipal bonds are exempt from federal taxes. For this reason, they are very popular among investors. These bonds are also considered safer investments since cities don’t go bankrupt too often.
  • Zero Coupon Bond – These bonds offer no coupon payments.  Since there’s no coupon, zero coupon bonds are sold at large discounts. The return from the bond comes once the bond matures and you receive the par value.
  • Corporate Bonds – Corporations that need to raise capital for business operations issue these bonds. Since businesses are considered more risky, corporate bonds usually offer higher returns.
  • Treasury Inflation-Protected Securities (TIPS) – These are also considered very safe investments since the U.S. government back them. TIPS offer semi-annual coupon payments and protection against rising inflation because their par value rises with inflation.
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