You may have heard a lot about the popularity of investing in bonds lately. Perhaps you’re wondering what all the fuss is about and whether or not you should hop on the bond bandwagon. I thought we might look at some of the basics of bonds for beginners today.
What Is a Bond?
A bond is a debt instrument used by one party to borrow money from another. It’s sort of like an IOU. In most cases, the borrower agrees to pay a set percentage, or coupon rate, to the lender for the use of the borrowed money. The party borrowing the money is called the issuer. Corporations, governments, municipalities, or other agencies can issue bonds when they need to borrow money for a specific purpose. The buyers of those bonds are lending money to the issuer for a specific period of time. At the end of that period, the bond matures and the issuer must pay back the original amount in full. Here are the main components:
When bonds are initially issued, the price is the face value, or principal amount. They will usually trade close to par (their original face value) around the time of the issue date. Many bonds, however, are then traded in the secondary market where they can be bought and sold several times before they mature. The price of bonds in the secondary market can fluctuate based on perceived changes in the credit quality of the issuer, interest rate fluctuations, or supply and demand.
2. Interest Rate
This is the percentage of interest paid on the face value of the bond. It’s set when the bond is issued and is usually fixed, although some bonds are based on variable or floating rates. Variable rates are usually pegged to a benchmark like LIBOR (London Interbank Offered Rate) or the prime rate.
Yield can be confusing for bond beginners. Isn’t yield just the same thing as the interest rate? Not always. Here’s how it works: The yield is the annual interest payment divided by the purchase price of the bond. One of the key things to remember about bonds is that price and yield always move in opposite directions. If the price of the bond falls, the yield rises, and vice versa. That’s because the interest rate is always based upon the original face value of the bond, not the fluctuating prices thereafter. Here’s some math that explains why:
Let’s go through a few examples based on a bond that is priced at $1000 and carries an interest rate of 3% per year. That means the annual interest payment would be $30 (Math: $1000 x .03 = $30).
Scenario #1: “When-Issued”
If the price of the bond stays the same, then the yield and the interest rate will be the same:
Annual Interest Payment/Purchase Price = $30/$1000 = .03 = 3%
Scenario #2: The Price Falls
Suppose our bond is traded in the secondary market and the price falls to $900 because interest rates are rising, the quality of the borrower has decreased, or there are more sellers than buyers:
Annual Interest Payment/Purchase Price = $30/$900 = .0333 = 3.33%
Scenario #3: The Price Rises
Maybe interest rates are falling and demand for bonds is rising, or the borrower’s cash balance has increased for some reason making them a higher quality borrower. That means our bond’s price is probably rising too. Suppose it rises to $1100:
Annual Interest Payment/Purchase Price = $30/$1100 = .0272 = 2.72%
It’s important to note that if you hold your bond to maturity, your yield will always equal your interest rate unless the issuer defaults. That’s extremely rare for higher quality credits like government and high-rated corporate bonds, but it’s not impossible.
Bonds can be issued with different maturities depending on how long the issuer intends to take to pay the money back. Very short term bonds exist with maturities of 30, 60, or 90 days. Those are currently paying close to 0%. Short term bonds mature in 1 – 5 years, medium term bonds mature in 5 – 12 years, and long term bonds usually carry maturity dates over 12 years.
The upper limit of long term bonds is usually 30 years, but there have been rumblings lately of 100 year bonds, or even perpetual bonds! That’s because the U.S. government and several others, have extremely high budget deficits that they will need to finance somehow. I don’t know about you, but I’m not interested in buying a bond that will live longer than I will.
Should You Invest in Bonds?
The short answer is yes. Bonds can be a key part of a balanced retirement plan. They are generally considered less risky than stocks, but they have also been rising in price for the better part of 30 years. That could continue a little longer, but logic and history tell us that the best days for bonds may have passed for the time being, so caution is warranted.
If you have a portion of your portfolio that you don’t want to put at risk in stocks or bonds, you might want to consider a CD ladder or even a high interest savings account. Neither will pay a great deal of interest, but you won’t lose any money either. These types of savings vehicles can also be a safe place to keep your money while you ride out stock market volatility or decide where to invest.
Do you have any experience investing in bonds?