Many investment professionals advocate holding a diversified portfolio comprised of a mix of stocks, bonds and cash. However, when considering appropriate investment vehicles, some self-directed traders tend to overlook bonds completely. (But obviously you’re not one of them or you wouldn’t be reading this. So bully for you.)
So what’s a bond, anyhow? Excellent question. We’re glad you asked.
When individuals need to borrow money, for example to buy a home, they’ll typically go to a bank and take out a mortgage. But when large corporations, municipalities, governments and other such entities need vast sums of money to build a new manufacturing plant, create a new mass transit service, or fund large-scale research, they can’t just walk into their friendly neighborhood bank branch and get the cash they need. Since banks alone can’t meet their high borrowing requirements, such entities sometimes choose to raise money by issuing bonds to the general public.
Bonds are a type of investment known as a “debt security”. You can think of the bond itself as a sort of IOU, because when you buy a bond you’re actually loaning money to the entity that issued it. In exchange for the loan, you’ll be paid a specified rate of interest over a set period of time. When the bond “matures” or “comes due” you’ll presumably get back its full face value. (We say “presumably” here, since there’s always the risk that the bond issuer won’t be able to pay you back. More on that later.)
There are several different kinds of bonds, each with a different set of risks and rewards, depending on the issuer. Types of bonds available include U.S. federal government securities (collectively referred to as “Treasuries”), municipal bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign government bonds. All types of bonds work according to the same basic principle: interest paid in exchange for a loan until the loan is repaid.
Anatomy of a bond
All bonds have these three characteristics: face value, coupon, and maturity date. A fourth characteristic, duration, is a calculated value which helps you assess interest rate risk. We’ll define each characteristic, tell you how they enable bonds to serve as a source of “fixed income” for a set period of time, and give you an example showing how it all comes into play.
Face value, or “par” for the course
The face value is the amount of money you’ll receive from the issuer when a bond reaches its maturity date. Interestingly, the face value is not necessarily the amount of money you’ll pay for the bond, known as the principal. Occasionally you may see these terms used interchangeably, but they are not the same.
Bonds are issued with even-denomination face values. Much of the time the face value, or “par value,” will be $1,000, but it may also be some other figure like $5,000, $10,000, or $20,000. Bond prices are expressed in units of $100, which you can think of as representing a percentage of the face value. For example, if a $1,000 bond is trading in the secondary market at a price of $98.475, you’ll pay $984.75, or 98.475% of the bond’s face value. If a $5,000 bond is trading at a price of $98.475, you’ll actually pay $4923.75 for the bond — once again 98.475% of the bond’s face value.
Some bonds trade for more than the face value (at a “premium”), while others trade for less than face value (at a “discount”). In fact, the value of a bond will fluctuate throughout its life span depending on several factors like market conditions, prevailing interest rates and the issuer’s credit rating.
A bond’s face value is also frequently referred to as the “par value” of the bond. These terms mean the same thing, so don’t get confused, confounded or discombobulated when you run into them being used interchangeably. Just remember, par value equals the face value of a bond.
The coupon is the amount of interest paid on the bond. It’s called the coupon because bonds used to feature actual coupons that you would tear off and redeem to receive the interest payments. For the most part physical coupons are a thing of the past, and now interest payments are almost always handled electronically.
If a bond has a face value of $10,000 and the coupon is 8%, then the holder will receive $800 interest every year over the life of the bond. Most bonds pay the coupon every six months, but some may pay monthly, quarterly or annually. Still others will pay compounded interest along with the face value on the date the bond matures. Whenever you buy a bond, make sure you know the exact terms of the coupon and when it will be paid.
Bonds with shorter life spans usually pay lower rates of interest than long-term bonds. That’s because short-term bonds tend to have lower risk. Bonds with longer life spans usually pay higher interest to compensate the buyer for potentially greater fluctuations in the general marketplace, changes in prevailing interest rates and risks associated with the issuer’s ability to pay the coupon or repay the bond’s face value at maturity.
Coupons allow you to reap the rewards of your money working for you, instead of you working for your money. When you reinvest coupons, that's the equivalent of getting your money to work overtime. This is also known as the power of compounding. Although each coupon may seem too small to invest on its own, the amount accumulated over the course of a year can be significant. If you place these coupon payments in a savings account, you will likely have enough funds to make another investment. Consider reinvesting coupons on an annual basis.
The maturity date is the day when the issuer has promised to repay the holder the full face value of the bond. Maturity dates of bonds typically range from one to 30 years from the date of issue, but it’s not unheard of for bonds to have a life span of as little as one day or even as long as 100 years.
It’s important to note that when you buy a bond, you’re not stuck with it until the maturity date. Like most other securities, bonds can be bought or sold on the open market at any time during their life span. Bonds with longer maturities are more sensitive to changes in interest rates.
This is a calculated value indicating how much a bond’s price may change with result to changes in interest rates. The higher the duration, the more sensitive the bond’s price is to interest rate fluctuations. Calculating duration is based on its time-to-maturity, coupon payments, the redemption value of the bond compared to purchase price, and when all financial payments occur. Duration is expressed in years.
The meaning of “fixed income”
Bonds are often called “fixed income” investments because the amount of money you receive and the dates on which you receive payments are specified in advance, or “fixed.” Typically, fixed income securities are regarded as having less risk than stocks. However, like all forms of investment bonds do involve risk.
An example of a bond
Imagine a manufacturing firm called Drive Rite Motors, Inc., needs to raise capital to expand their facility and buy new equipment. To raise the funds, they decide to issue 10-year bonds with a face value of $1,000 and a 6% coupon payable semi-annually.
Before buying Drive Rite Motors bonds, you’d want to be reasonably certain the firm would remain solvent for the ten-year life span of the investment. That way, they’ll be able to pay the coupon over time, and ultimately return the bond’s face value to you on the maturity date. Assuming that to be the case, let’s say you bought ten Drive Rite Motors bonds with an issue date of June 29, 2010. What now?
First, let’s calculate how much you’d receive in interest every year. Ten Drive Rite Motors bonds with a face value of $1,000 each equals a $10,000 initial investment. At a 6% coupon, you’ll receive $600 per year in interest ($10,000 x .06 = $600).
Since the coupon is payable semi-annually, you’ll receive a payment of $300 from Drive Rite Motors every six months ($600 / 2 = $300) on December 29th and June 29th until the bond’s maturity date. Over ten years, you’ll receive 20 payments of $300 totaling $6,000 (20 x $300 = $6,000) until June 29th, 2020. On that day you’ll get the final interest payment along with your entire $10,000 principal investment back from Drive Rite Motors.
Drive Rite Motors
Face value = $1,000 per bond
Initial investment = $10,000 (10 x $1000)
Coupon = 6% paid twice annually
Maturity = June 29th, 2020 Interest equals $600 per year ($10,000 x .06 = $600)
Your fixed income = $300 every 6 months ($600 / 2 = $300)
Over 10 years you get $6,000 in interest payments
That’s 60% of your initial capital. Not too shabby.
Don’t count your coupon payments before they’ve hatched
Some bonds stipulate that the issuer may have the right, but not the obligation, to buy the bond back before the maturity date on a day known as the “call date.” Such bonds are referred to as “callable” or “redeemable” bonds. This feature is in place to benefit the issuer. However, if a bond is called early, that brings some good news and bad news for you as the investor.
The bad news is interest payments cease after the call date. The good news is you’ll get back your principal investment, plus a premium since the call price is usually slightly more than the face value of the bond.
Let’s say Drive Rite Motors’ bonds are callable, entitling them to buy back the bonds on June 29th, 2015 at 102.5% of the face value. If increased profitability from their new equipment and expanded facilities makes it possible to pay the money they borrowed back early, it might make sense to do so instead of shelling out more interest payments over time.
If Drive Rite Motors calls your ten bonds on June 25th 2015, you’ll get back 102.5% of your initial $10,000 investment, or $10,250. From that point, the bonds are considered cancelled and interest payments cease. But look on the bright side: you would have already received $3,000 in interest, plus a $250 premium, and you’re free to invest your capital somewhere else.
Bonds can be “puttable”, too. (You pronounce that like the verb “to put”, not like “putting” in miniature golf.) If a bond happens to be puttable, you retain the right to demand repayment of the face value of your bond. In a rising interest-rate environment, it might make sense to “put” your old bond to the issuer, collect your principal, and reinvest it in a bond with a higher interest rate.
You pay for this perk, however. Puttable bonds tend to pay a lower interest rate than comparable bonds without this feature. You can’t exercise your put any old time you please, either - the issuer usually specifies put dates when you’re free for a limited time to pull the trigger.
In addition, some bond contracts contain clauses allowing the issuer to suspend coupon payments without being considered in default, or have variable interest that can result in a coupon of 0% for some period of time. So keep your magnifying spectacles handy and be sure to read the fine print.
Money in the bank, or junk in the trunk?
There’s always the risk that any bond issuer will become insolvent and default on the bond. In that case, you’d have to engage in some legal wrangling to receive even a small portion of the money that’s owed to you for the coupon and face value of the bonds. Don’t be tempted by the higher interest that comes with high-risk “junk” bonds.
Debt securities vs. equity securities
What’s the difference?
Debt securities like bonds and equity securities like stocks have their own unique sets of risks and rewards. One is not necessarily better than the other. It’s up to you to analyze which securities are right for you and how they fit into your overall portfolio. In fact, chances are you’ll opt to invest in a blend of bonds, stocks and other securities as part of your overall asset allocation plan.
Owner vs. creditor
When you buy stock in a company, you become part owner of that firm. As part owner, you may receive certain privileges, like voting rights and a share of profits via dividends (provided you have purchased a dividend-paying stock).
When you buy a bond, you don’t own any stake in the entity that issued it. You’re simply a creditor. That means you have no say in how the issuing entity is run, and the only return you’ll receive is the interest paid on the bond.
However, as opposed to shareholders, bond owners receive income even if the issuer isn’t performing so well. If you purchase corporate bonds, whether the firm meets with success or difficulty, provided the company stays afloat your rate of return remains the same. So you’re not as exposed to fluctuations in the issuer’s performance. Furthermore, if a firm goes bankrupt, bond owners have a much higher claim to assets than shareholders, who may stand to lose their entire investment.
Asset appreciation vs. asset preservation with income
When you buy a stock, you’re speculating that the stock will increase in value and your assets will appreciate over time. But that’s not necessarily the case. While some stocks outperform the market, others will underperform or even lose their value entirely.
When you buy bonds, you’re preserving your assets because the face value of the bond doesn’t change and (depending on the financial stability of the issuer) you can reasonably expect to be paid back in full on the bond’s maturity date. In addition, you can expect to receive income from interest payments at regular intervals throughout the life of the bond.
Sale of debt
Sale of equity
Owner is a creditor to the issuer
Owner obtains stake in the issuer
Return of principal is promised
Principal is at full risk
No voting rights
Usually has voting rights
Generates periodic interest payments regardless of issuer’s performance
May generate regular or special dividends if issuer is profitable
More legal rights for non-payment
Limited rights for non-performance
High priority for repayment in case of issuer bankruptcy
Low priority for repayment in case of issuer bankruptcy
Prices fluctuate over time but face value remains stable.
Prices fluctuate over time
Why invest in bonds?
The reason for investing in bonds should be patently obvious: to make money. Perhaps a better way to phrase the question is, “Why invest in bonds instead of stocks, when stocks may have a greater upside?”
Depending on your circumstances, investment objectives and risk tolerance, bonds can play an important role in your overall portfolio. Here are just a few reasons you may wish to consider for diversifying your portfolio with bonds instead of investing solely in stocks.
Bonds are generally a reliable source of income
When you invest in stocks, you’re exposed not just to the performance of the company, but also to the overall whims of the market. With bonds, by contrast, you always know how much money you’re going to receive and when you’ll receive it. So bonds provide a fairly predictable stream of income unlike stocks.
To reduce the overall risk of your portfolio
Stocks might go up over time, sometimes with spectacular results. But they also may remain stagnant, go down, and in some rare cases (like certain bankrupted auto makers and dot-coms that we won’t name here) they may actually go to zero. On the other hand, since the issuer has promised to repay 100% of the bond’s face value, bonds can be a more secure way to maintain the value of your principal investment while still receiving acceptable returns.
That’s not to say bonds are completely without risk. In fact, depending on the issuer, some bonds may have more risks than some stocks. It’s possible the issuer won’t be able to make interest payments, and they might not repay the loan at all (known as “defaulting”), which could result in total loss of your investment. Nevertheless, in general, bonds tend to be less risky than stocks. The basic concept to grasp here is that bonds tend to be a lower-risk (and therefore lower-return) investment than stocks.
Asset allocation and the Rule of 100
One way to reduce risk in your portfolio is to use the method of asset allocation. A good rule-of-thumb is the “Rule of 100”. Simply subtract your age from 100 - that’s the percentage you should consider investing in stocks. For a 30-year-old, that means investing 70% of your assets in stocks (100-30) and the remainder, 30%, in bonds. As you get older, that balance starts to see-saw the other way. At 55, the 100 rule would suggest you should invest 45% of your assets in stocks and 55% in bonds. At 70, you might shift to 30% stocks and 70% bonds.
But check your gut here: if you’re a younger, somewhat more aggressive investor, you might prefer substituting the 100 rule with 120. This rule involves the same math, but yields a more-aggressive asset allocation: a 30-year-old would invest 90% in stocks and 10% in bonds, while the 70-year-old would invest 50% in stocks and 50% in bonds. You may wish to transition to the Rule of 100 as you get older.
You want to invest with a shorter time horizon
When you invest in stocks, it can be fairly unpredictable when you’ll see a return on your investment. A stock you’re bullish on in the long-term might remain stagnant or experience a dip in the short-term. On the other hand, with bonds you know exactly how much you should receive and how long it will take to receive it.
If you want to see some return on your investment capital in a relatively short period of time (five years or less) while remaining fairly certain you’ll preserve your capital, bonds may be right for that scenario. As you near a financial goal like paying for college, you’ll probably want to shift more of your investments towards that goal into capital-preserving assets like bonds.
Investments leading up to and during retirement
Because bonds tend to be less volatile than stocks, as you approach retirement it can be wise to reduce your exposure to the potential downside of the stock market. If all of your money is invested in stocks and the market is completely in the tank, you might not want to sell your shares, preferring instead to wait for a rebound. If you’re retired, you may be forced to do so anyway in order to meet your expenses.
The interest you receive from bonds, on the other hand, can provide a source of “fixed income” that you use to pay your bills during retirement while preserving a known percentage of your investment capital. As a result, some investors choose to weight their portfolios more heavily toward bonds as retirement approaches.
You want tax advantages on your investment
Not only can bonds generate a regular income stream for the investor, sometimes that income stream may be tax-free. So they can be especially attractive to investors with a high tax burden. Of course, the tax ramifications will depend on the type of bond, the bond issuer and the state in which the investor resides. Make sure you check with your tax or financial advisor for more information on bonds that may reduce your tax exposure.
Risks of bond investing
Bonds are the poster-child of “safe” investments - but even bonds will expose you to risks as an investor.
- Interest rate risk: Also known as market risk, this refers to changes in bond prices due to changes in interest rates. Bond prices and interest rates behave as if they are on opposite ends of a see-saw: as interest rates increase, prices of existing bonds decrease. This is probably the biggest concern for bond investors.
- Credit risk: The two main objectives for bond investors is to receive interest payments on time and to receive the face value of their investment back at maturity. Credit risk is the chance of either of these events not occuring as anticipated due to the issuer’s financial trouble. Credit risk is nearly as important as interest rate risk.
- Inflation risk: Inflation makes tomorrow’s dollar worth less than today’s, eating away at the purchasing power of your future interest payments and principal. The Fed may combat high rates of inflation by raising interest rates; that in turn leads to lower bond prices.
- Reinvestment risk: This one’s a biggie for longer-term bond investors particularly. When interest rates decline, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at the new, lower prevailing rates.
- Selection risk: Also in play with investments other than bonds, this is the risk that you’ll choose a security that underperforms the broader market. You can reduce selection risk with smart research and less reliance on the ole dartboard to pick your securities.
- Timing risk: The risk that an investment performs poorly after you buy it or better after you sell.
- Additional expenses: Don’t overlook the costs associated with investing, like commissions, markups, markdowns or other fees. If those costs are excessive, they can detract significantly from your net return.