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What Are Bonds?

Roger Wohlner is a writer and financial advisor with over 20 years of financial services experience. He writes about financial planning for Wealthsimple and for a number of financial advisors. His work has been published in Investopedia, Yahoo! Finance, The Motley Fool, Money.com, US News among other publications. Roger owns his own finance blog called 'The Chicago Financial Planner'. He holds an MBA from Marquette University and a Bachelor’s degree with an emphasis on finance from the University of Wisconsin-Oshkosh.

A bond is a fixed income security in which the investor loans money to the entity who issued the bond. Bonds are issued by corporations, state and local governments, non-profit institutions, and the federal government.

Just like a bank loan, a bond contains terms for the repayment of the principle amount of the bond, as well as any periodic interest payments to be made prior to the bond’s maturity.

Missing interest payments, or even worse defaulting on the repayment of the bond’s principal, can put the issuer in a precarious financial position, and even lead to bankruptcy.

Investing in bonds

There are a number of ways to invest in bonds.

  • Individual bonds can be purchased as a new issue when offered by the issuer. This may require a minimum investment, which may be sizable.

  • The U.S. Treasury does a weekly auction of its newly issued securities, at which small investors can make a non-competitive bid, which means their purchase will be made at the average price for all bidders on the particular security they are bidding on. This could be notes, T-Bills, etc.

  • Bonds can be purchased on the secondary markets. These are “used” bonds along the same lines as shares of stock that are already issued and that trade on exchanges. This is often done via brokers like Fidelity and others. The process is not quite as straightforward as with stocks. There is a spread between the price you will actually pay and what the broker obtains the bonds for. This spread is their profit and can be sizable for smaller investors.

  • Bond mutual funds and ETFs can be a good way for individual investors to invest in bonds. There are funds that invest in most types of bonds, including treasuries, corporates, municipal bonds, governmental bonds and others. There are bond funds and ETFs that are actively managed and others that track an index. There are funds that invest in short-term, intermediate term and long term bonds. Within these and other categories of bond funds there are many that are a combination of these characteristics.

  • One thing to remember with bond funds and ETFs is that they never mature. Individual bonds do mature, at which time the investor received the face value of the bond. This doesn’t happen in a fund or an ETF and investors need to be cognizant of this.

Investing in bonds can add diversification to your portfolio, however it is important to understand what you are investing in.

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Examples of bonds

As mentioned above, bonds are issued by both governmental and corporate issuers. Some examples of bonds include:

U.S. Treasury Securities

The U.S. Treasury issues a number of different types of debt securities including:

  • Treasury bills, or T-bills, are very short-term bonds issued by the Treasury with a maturity of one-year or less.

  • Treasury notes are debt securities with a maturity ranging between 1-10 years.

  • Treasury bonds are longer term securities with maturities ranging from 10 to 30 years. They are a form of longer term funding for the federal government.

  • Treasury inflation protected securities (TIPs) are bonds designed to help protect the investors in these bonds from inflation. The bonds are indexed to inflation, meaning that the principal value of the bond is increased based on the consumer price index, a major indicator of the level of inflation in the U.S. economy. The interest payments are calculated on the new principal value of the bond, and the payment upon maturity reflects this as well.

Municipal bonds

Municipal bonds are issued by states, cities and other governmental entities other than the federal government. These bonds are secured by things like tax revenues, revenues based upon a project they may be backing or other means.

The advantage to municipal bonds is that the interest received is exempt from federal taxes and in some cases may be exempt from state income taxes.

Muni bonds are subject to bond ratings as the finances of the issuer can vary widely. An extreme case in point is the situation in Detroit a few years ago when the city essentially went bankrupt and defaulted on it bond debts.

Corporate bonds

Many corporations issue bonds as a method of debt financing. Well-diversified companies will have a mix of debt, both from bonds and perhaps from bank loans, and equity in their financing structure on their balance sheet. Corporations like utilities and many manufactures will often issue bonds to finance long-term capital projects.

Risk of investing bonds

Bonds are generally considered to be less risky than stocks, but with the exception of bonds issued by the U.S. Treasury which are considered to be a risk-free asset by most experts, bonds do carry the risk of default if the issuer can’t make interest payments or redeem the bonds at maturity.

Bonds, even treasuries, do carry several risks.

Interest Rate Risk

The price of bonds on the secondary markets move inversely with the level of interest rates. For example, if a bond with a face value of $1,000 pays 4% interest, this means that the bond holder will receive $40 in interest payments during the year. If interest rates on bonds with a comparable maturity and credit quality rise to 5%, this means that this bond holder will receive $50 in interest payments annually.

If the holder of the bond that pays a 4% interest wants to sell it, it’s unlikely that an investor looking to buy a bond of that type will pay $1,000 for it in the secondary market. Why would they pay $1,000 for a 4% return when they can buy the bond paying 5% for the same $1,000? More likely, they would only pay $800 for this bond as that is the price at which the $40 annual interest payments would equate to a 5% annual yield on the bond.

Default Risk

This refers to the issuer of the bond not being able to pay the face amount of the bond upon maturity. While there is no default risk for bonds and other debt securities issued by the U.S. Treasury, all other types of bonds and bond issuers do carry this potential risk.

A bond with a face value of $1,000 that matures in 10 years means that the issuer of the bond will repay the $1,000 to the bond holder on the date indicated. Failure to make that payment could result in the issuer defaulting on the bonds and could be an indicator of worse problems for the issuer, whether a company or a state or local government.

Various bond rating agencies, such as Standard & Poor’s, Moody’s, and Fitch, assign ratings to various bonds and their issuers based on their assessment of their creditworthiness and financial health. They do this with an eye toward the issuer’s ability to service and make all payments on these bonds.

The ratings usually are made with letters. For example, a Standard & Poor’s rating of less than BBB is generally considered less than investment grade or a “junk bond.” The higher a bond’s rating, generally the lower the interest rate that the issuer will be required to pay in order to entice bond investors to invest in the bonds.

Inflation Risk

This applies to most bonds, with TIPs issued by the U.S. Treasury being a notable exception. The amount received upon the bond’s maturity is fixed, as are the periodic interest payments received. If the level of inflation increases drastically, the purchasing power of these bond payments will be reduced. Other types of investment assets like stocks, real estate, and some others offer better protection against inflation in many cases.

Duration Risk

Duration risk deals with the time until the bond matures. The longer it takes the bond to mature, the greater the risk. A longer time horizon means more things that might negatively impact the bond.

Different bond issuers have various purposes in mind when issuing bonds.

  • The U.S. Treasury issues very short-term T-bills plus notes and bonds with longer maturities as a means to finance the operations of the federal government.

  • State and local governments issue bonds to both finance the various services and operations they offer, plus they may issue bonds to fund specific projects like roads or other types of construction. In some cases, they may need the funding for things like pension obligations for public-sector workers.

  • Corporations issue bonds to fund corporate growth and to fund capital expenditures like a new facility or others. Bonds are a part of the company’s capital structure along with the equity portion of the balance sheet.

Bonds can range from short-term maturities to those that mature in 30 years or longer.

Bonds versus stocks

Bonds represent a loan to the bond issuer that needs to be repaid at a predetermined time. Bond investors are essentially acting as a banker to the issuer. Stocks represent an ownership interest in the company issuing the stock. Stock investors are hoping that the company will do well financially and that the business will grow, creating the potential for the price to increase.

The main way in which bond investors are compensated are the interest payments on the bonds, based upon the coupon (stated) rate of the bond. The main reason to invest in stocks is the prospect of price appreciation on the shares. The main reason to invest in bonds is the virtual certainty that your investment will be repaid with interest.

Last Updated May 14, 2020

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