1. What are bonds?
Let us start off with a simple question. Have you ever borrowed money? Maybe something like a loan or you borrowed it from a friend? You most likely did, but if you haven’t, good for you.
So, we came to a conclusion that people need money for certain things, such as new TV, a new car or something else. Just as people, companies and governments need money too, not for new TVs, but for further investments, repaying old loans and so on. A company might need funds to expand into a new market, develop new products and so on. The problem lies in the quantity of the said money. Most of the times, the quantity is so large, even banks won’t lend them. At this point, the solution is to collect money by issuing bonds to a public market. In that case, hundreds or even thousands of investors lend the money to a company or a government. The organization that sells bonds is known as the issuer. Think bonds as an IOU given by a borrower to a lender.
Now you might ask yourself, why would anyone in their right mind even lend their hard-earned money for nothing? The issuer of a bond must pay the investor something extra for their money. This “extra” is called an interest payment. They are made at a predetermined rate and schedule. This interest rate is often called a coupon. The date on which the issuer has to repay the amount a government or a company borrowed is called the maturity date. Bonds are relatively safe and they are known as fixed-income securities because you know the exact amount of money you’ll get back if you hold the bond or the security until the maturity date.
Here is a simple example. If you buy a bond with a value of $1,000, a coupon of 10%, and a maturity date of 10 years. This means you’ll receive a total of $100 of interest per year for the next year. Actually, most bonds pay semi-annually (two times per year), in that case, you’ll receive two payments of $50 for 10 years. When the bonds mature after 10 years, you’ll get your $1,000 back. Of course, not only you got $1,000 back, but you earned $1,000 on top of the $1,000 borrowed. That is how bonds work.
2. Bonds vs. stocks
When you buy a bond, that means you lend your money to a government or a corporation, when you buy stock, on the other hand, you (an investor) become an owner in the said corporation. Ownership has certain privileges like voting right and dividends. Also, it is important to note that when you buy a bond, an investor becomes a creditor a corporation or a government. Obvious advantage between the two is that when you are a creditor you have a higher claim on assets than a shareholder. That means, in a case of a bankruptcy, a bondholder will get paid before the shareholder. On the other hand, bondholder does not share any profits or is entitled to voting rights.
What have we learned so far? Bonds usually carry much lower risk than a stock, but this comes at a certain cost. Bonds have much lower return than stocks.
3. Bond characteristics
We learned so far that bonds have a face value, maturity date, and interest rate. All of these characteristics or factors if you like to play a role in determining the value of a bond.
3. 1. Face Value
The face value which is also known as par value or even principal is the amount of money a holder will get back once a bond matures. A bond that is was issued recently usually sells at the par value/face value. Also, it is important to say that corporate bonds usually have face value of $1,000, but this amount can be much greater for government bonds
Many people don’t understand that the face value/par value is not the price of the bond. A bond’s price fluctuates and it is dependent on a number of factors. For now, it is important to know that if the bond is selling above the face value, it is selling at a premium. On the other hand, if the bond sells below face value, it is selling at a discount.
3. 2. Coupon or the interest rate
Coupon or interest rate is the amount the owner of the bond will receive as interest payments. It’s called a “coupon” because there was actual physical coupon issued to the bondholder. However, this practice was much more common in the past. Nowadays, everything is transferred electronically.
As mentioned already, most bonds pay semi-annually or every 6 months if you will, but there are bonds that pay monthly, quarterly or annually.
3. 3. Maturity date
A maturity date is a date in the future on which the investor’s principal will be repaid. Maturities can range from as little as one day to as long as 30 years!
A bond that matures in one year or so is much more predictable and, therefore, less risky than a bond that matures in 30 years. Therefore, the general rule applies, the longer the time to maturity, the higher the return rate and thus higher the return the investor will get. Also, let’s not forget that a longer term bond will fluctuate more than a shorter term bond.
3. 4. The issuer
The issuer of a bond is a crucial factor to consider when buying a bond or bonds. Why, you might ask? Because the issuer’s stability is your main assurance of getting paid back. Here is a quick example. The U.S. government is far more secure than any other company out there. Its default risk is extremely small, almost non-existent therefore U.S government securities are usually known as risk-free assets. There are considered risk-free assets because they will be able to in future revenue through taxes. On the hand, we have a company, that has to bring in profits through sales, which is far from guaranteed. Also, corporate bonds must offer a higher yield in order to entice investors.
The bond rating system helps investors determine a company’s or a government’s credit risk. We have blue-chip firms, they are usually the safest investments, they have a high rating while risky companies have a low rating. The chart below illustrates the different bond rating from some major credit rating agencies in the U.S. such as Moody’s, S&P and Fitch Ratings.
In the table above, we can see that a company or a government can fall under different categories. Its grade can change from Investment grade to Junk grade. Junk bonds are named junk because the companies or governments are usually in a difficult financial situation (read: debt). Because, they are so risky, they will offer a higher yield.
4. What type of bonds are out there?
4. 1. Corporate bonds
A company can issue bonds just as it issues stocks. Large, international corporations have a lot of flexibility as to how much debt they can issue, the limit is whatever the market can handle. In general, they are short-term, intermediate and long-term bonds. The short-term corporate bonds maturity date is less than five years; intermediate is five to twelve years and finally, long-term bonds is over twelve years.
Corporate bonds are usually characterized by higher yield because of the higher risk as a company has much greater risk of defaulting than an average government. Don’t forget about the company’s credit quality as it will affect the interest rate as well. The lower the quality, the higher the interest rate the investor receives.
There are some variations of corporate bonds and some of them are convertible bonds, they are called convertible bonds as they can be converted into stocks and callable bonds. Callable bonds allow they company to redeem as an issue prior to maturity.
4. 2. Government bonds
Government bonds are called fixed-income securities. There are three main categories of them.
Bills – debt securities that are maturing in less than one year.
Notes – debt securities that are maturing in one to ten years.
Bonds – debt securities that are maturing in more than ten years.
Securities that any investor can buy from the U.S. governments are collectively known as Treasuries. Technically speaking, T-bills aren’t bonds because of their short maturity date. All government bonds issued by U.S. government are extremely safe, the risk around them is almost non-existent. On the other hand, some countries that are still in development carry some risk. Like companies, governments can default on payments.
4. 3. Municipal bonds
Municipal bonds simply called, “munis”, are the in line in the terms of risk. Cities don’t often go bankrupt that often, but of course, that can happen too. The major advantage to municipal bonds is that they are completely free from federal tax. Moreover, some local governments can make their bonds completely non-taxable for residents which make municipal bonds completely tax free. It is important to note that the yield on a municipal bond is usually much lower than that of a taxable bond.
4. 4. Zero-coupon bonds
Zero-coupon bonds are a special type of bonds that make no coupon payment as the name says, but instead, is issued at a considerable discount to par value.
4. 4. Catastrophe bonds
Also known as CAT, they are special kinds of bonds that are generally issued when any sort of catastrophe comes up. For example, an earthquake or a hurricane. They act as a high-yield debt instrument and they have few special conditions that basically state if the issuer suffers any of the catastrophes that were predefined by the agreement, then the issuer’s obligation to pay interest and/or repay the principal is either deferred or completely forgiven.
For example, a natural catastrophe such as an earthquake has a hazard probability of 1% (applies to earthquake magnitude of Richter 8.0). They are usually rated BB/BB- by various rating agencies (source).
5. Bond table – what is it and how to read it?
Column 1: Issuer – column 1 represents the issuer. The issuer can be a company, state or a country that is issuing the bond.
Column 2: Coupon – under column 2 we have the coupon. It refers to the fixed interest rate that the issuer pays to the lender.
Column 3: Maturity date – maturity date is the date on which the borrower will repay the investor their principal.
Column 4: Bid price – bid price that is someone willing to pay for the bond. It is quoted in direct relation to 100, the par value does not matter here. You can think off the bid price as a percentage. For example; a bond with a bid price of 91 is trading at 91% of its par or face value.
Column 5: Yield – we talked about yield before. Yield indicates annual return until the bond matures.
6. How can I buy bonds?
You can buy the most bonds as normal transactions with the help of a discount brokerage or a full service. Also, we can always open an account with a bond broker, but be warned as most bond brokers require a minimum initial deposit of $5,000. If you cannot afford this amount, fear not. I suggest that you should look for a mutual fund that specializes in bonds.
How can I buy government securities? Some financial institutions will provide the service of transacting government securities. Now, if you bank doesn’t provide this service and you don’t have an access to a brokerage account, you can purchase government securities through a government agency.
Beware of brokers, as they might say that purchasing a bond through a broker is commission free. Don’t be taken as a fool. Usually, if this is the case, he will mark up his price slightly; this markup acts as a commission.
To sum it all up, you should do your research just as you would do your research when you are buying stocks.
7. What have we learned?
Now you can proudly say that you know the basics of bonds. Here is a small recap of what we have learned:
• Bonds = IOUs. When you are buying bonds, it means you are lending your money to a company or government.
• Bonds are also called fixed-income securities because the cash flow from them fixed.
• Bonds = debt. Stocks = equity
• Basic bond characteristics are face value, coupon rate, maturity date, and issue.
• Yield is defined as the rate of return we get on our bond.
• Government bonds are the safest, followed by municipal bonds and finally, corporate bonds.
• High-risk/high-yield bonds are also known as junk bonds.
• We can purchase a bond through a bank or brokerage or even through a government.
• Brokers usually won’t charge any commission on bonds, but they will mark up their price instead.