In this week’s post, I explain the basics of bonds.
When most people think of investing, they immediately think of the stock market, which we discussed last week. In my opinion, this is due to the fact that stocks are much more volatile, more exciting, and have historically produced higher returns than bonds. However, the bond market is much larger than the stock market and bonds play a very important role in many investors' portfolios and the global financial system.
As I have emphasized, remember that investment securities, such as bonds, are distinct from the type of investment account in which they are held, as we covered in a post several weeks ago. Each type of security has its own characteristics that are separate from the rules and tax treatment of the investment account. This post will explore some of the characteristics of bonds.
Bonds are loans
Bonds are loans – the buyer of a bond is loaning money to the institution selling the bond. In exchange for this loan, the bondholder is promised interest and to have their money returned. There are different types of bonds with unique characteristics, but this post will focus on fixed-coupon bonds that pay interest twice a year (semi-annually).
An institution will sell bonds to raise money for a variety of purposes. For example, a company might want to build a factory, or a government might need to finance a war. Bonds are sold with a “face value,” which is the value that the issuer will pay to the bondholder at maturity and the value that interest is calculated on. “Face value” is interchangeable with “par value.” The face value of each bond is typically $1,000. Due to market forces, bonds will not always be sold at precisely face value.
The issuing institution will pay the investor the interest rate on the bond, which is called the coupon rate. The coupon rate is multiplied by the face value to determine the dollar amount of the payment. For example, if a bond has a 7% coupon rate and $1,000 face value, the issuer will pay the bondholder $70 a year (7% * $1,000). If payments are being made semi-annually, this payment would be split in half – in this example, $35 would be paid every six months. A fixed-coupon bond’s payment is contractually fixed, unlike the dividends of stocks - this is one reason why bonds are usually more stable and less volatile than stocks.
Bonds have different lifespans. The lifespan of a bond is called its “term.” At the end of a bond’s term, the face value amount is paid to the bondholder.
If an issuer becomes unable to make interest payments or principal payments to their bondholders, the bonds are in “default.” For corporate bonds, bondholders have preference over stockholders in liquidation – bondholders will get their money back before stockholders get anything. This is another reason why bonds are considered less risky than stocks.
The price of a bond will fluctuate as market condition change. The price of a bond will often be different than the face value of the bond. For example, if a company is about to go bankrupt, its bonds may trade at prices that are substantially below their face value – investors don't think they will recover the full face value in liquidation. Prices will also change in the opposite direction of interest rates – if interest rates go up = bond prices go down; if interest rates go down = bond prices go up. This can be confusing, so let's look at an example:
There is a bond with a 5% coupon and $1,000 face value. The bondholder will receive $50 in interest each year (5% * $1,000). Interest rates increase dramatically to 12% for similar bonds. A bond with a 12% coupon will pay $120 in interest each year (12% * $1,000). Why would an investor want the old bond paying $50/year in interest when they can buy the new bond that pays $120/year in interest? Investors would only want the $50/year bond if they can buy it for much less than face value – the forgone interest needs to be made up for by the capital increase from the price they pay to the face value they will receive at maturity.
As mentioned, this description is of a fixed-coupon bond with semi-annual interest payments. There are a variety of other types of bonds, which we will not cover here, such as: zero-coupon bonds, TIPS, and floating rate bonds.
Example of a corporate bond
A company wants to build a new factory and decides to issue a bond with a 6% coupon, $1,000 face value, and two year term. The bond is sold to an investor at face value (as mentioned above, this will not always happen). The bond holder will receive $60 in interest each year – broken up into $30 semi-annual payments. The bondholder will receive the face value at the end of the two year term.
Here is a visual:
What types of institutions issue bonds?
Many different types of institutions issue bonds. The different types of bonds have unique characteristics:
Treasury bonds – treasury bonds are issued by the United States federal government. The bonds are issued to raise money to run the government - building infrastructure, funding wars, paying for social programs. Because treasury bonds are backed by the full power and credit of the federal government, and the government’s ability to print money through the Federal Reserve, treasury bonds are considered “risk-free” with basically no chance of default. Because they are “risk-free,” treasury bonds typically have the lowest interest rates.
Agency bonds – agency bonds are issued by certain government agencies or government sponsored entities. Some of these bonds are guaranteed by the federal government, while others are not.
Municipal bonds – municipal bonds (often called “munis”) are issued by state and local governments. Like treasury bonds, municipal bonds are sold to raise money to build infrastructure and fund general government operations. A unique feature of municipal bonds is that they are often exempt from federal income taxes. They can also sometimes be exempt from state income taxes. This can make munis especially attractive to investors who are in a high tax bracket.
Corporate bonds – corporate bonds are issued by companies. Companies may issue bonds to fund a particular project (for example, building a factory) or funding their general operations. Because companies can go bankrupt (and don’t have the privilege of printing money), corporate bonds are typically viewed as more risky than treasury bonds and thus bondholders demand a higher interest rate.
Mortgage-backed securities and asset-backed securities – mortgage-backed securities and asset-backed securities are bonds backed by pools of mortgages or other forms of debt, such as credit cards or car loans. Mortgage-backed securities might sound familiar, because of the role they played in contributing to the global financial crisis and “Great Recession” that occurred from 2007 to 2009.
Why do investors own bonds?
In last week’s post, we discussed the different reasons why investors own stocks. We discussed that a stockholder’s total return is made up of dividends and price appreciation. Investors buy bonds for similar reasons. Bondholders receive interest payments and can also benefit from capital appreciation if they buy the bond below face value. The price of a bond can also increase above face value.
Investors also buy bonds, because they are (generally) more stable and less risky than stocks and other risk assets, but still provide more income than cash. However, bonds are not completely without risk. Corporate bonds can suffer from default and all bonds can decline in price when interest rates rise.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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