Investing in Bonds for Beginners
Introduction to Bonds
What are Bonds
The beginner investor will probably have heard of bonds and the financial press frequently mentions them, but just exactly what are bonds.
A bond is nothing more than a loan, which means that the bond investor actually leads money to either a government agency or to a company for which in return the bond investor receives an interest payment.
The beginner investor may well be wondering why these government agencies and companies would want to borrow money from investors.
Why don't they just borrow the required money from a bank? Of course the bank is the first place anyone goes to; however banks tend to be quite conservative with gearing, which means they don't like to loan too much money to any one agency or company in order to manage their risk.
These government agencies and companies must therefore seek alternative sources to fulfill their funding requirements and the next cheapest source is to borrow money directly from investors.
The money raised by issuing bonds is used for a variety of purposes.
Bonds are often held in investing portfolios - usually as a means of smoothing out the returns, but this also tends to lower the returns over the long-term.
Bonds can be bought and sold through a bond broker. Some stock brokers also provide a bond brokerage service.
Common Government Issued Bonds
The common government issued bonds are U.S. treasury bonds and municipal bonds.
The U.S. federal government primarily issues Treasury bonds to finance its debt. They are considered to be the safest bonds and are issued with various maturities (the number of months or years until the loan is repaid).
- Treasury Bills: These are short term bonds with maturities of up to 52 weeks.
- Treasury Notes: These are longer-term bonds with maturities of two to ten years.
- Treasury Bonds: These are very long-term that typically mature in 30 years.
Treasury Inflation Protected Securities (TIPS) are notes and bonds where the original capital loaned is adjusted for inflation, which means that the amount paid at maturity is more than the original amount loaned (assuming inflation continued to increase during the loan term).
Other Types of Bonds
Municipal bonds are issued by states, cities, counties and other government agencies in order to finance their capital investments in schools, highways, hospitals and other projects.
Bonds issued by companies are referred to as corporate bonds and can be issued by public companies (listed on a stock exchange) or issued by private companies.
The capital raised from issuing bonds can be used to finance working capital, finance expansion or acquisitions.
Bonds typically pay interest twice a year and provide investors with a predictable income source.
Treasury bonds are the safest bonds with regards to both the reliability of interest payments and the repayment of the loan at the bonds maturity.
Corporate bonds generally pay higher interest rates than government bonds, but are considered less reliable.
Basically, the higher the interest paid, then the higher the probability that the interest may not be paid or that the loan would even be repaid at maturity.
Know your terminology
When a government agency or corporation issues a bond, the investor loans an agreed amount as stated on the bond certificate.
Also stated on the bond certificate is the interest rate and the frequency the bond investor will receive their interest payments.
The terminology used with bonds is consistent amongst the various categories of bonds and they are as follows:
- Issue date: This is the date that the bond was issued on.
- Interest rate: The interest rate on most bonds is a fixed amount and is often referred to as the coupon rate or coupon payment. The term "coupon" goes back to the days when bond holders held actual coupon booklets that the bond investor would present to receive their interest payment. Nowadays the interest payments are received electronically.
- Maturity date: The date that the bond will terminate and the face value is returned to the bond holder.
- Face Value: This is the amount that will be repaid at the bonds maturity date and is also referred to as "Par value" or "Principle". This is not necessarily the same as the original amount paid for the bond. For example, when treasury bonds are issued they are auctioned and buyers may pay more or they may pay less than the face value.
- Yield to Maturity: This yield calculation becomes relevant after the bond has been issued and its value now is probably different to the issue price. Thus for an investor buying this bond, the yield they will obtain is not the same as the interest rate.
Investors who acquired their bonds when they were issued have the option of selling their bonds on a secondary market known as an over-the-counter (OTC) market. This market consists of bond dealers who buy bonds from investors and in turn sell them to other investors who wish to buy them.
An analogy with stocks is that a bonds issue is like a stock's initial public offering (IPO) and just like a stock acquired from an IPO that can later be sold on a stock exchange, a bond that was issued can then be sold on the OTC market.
The Price Movement of Bonds
The amount that a bond can be sold for largely depends on the interest rate movements from the time the bond was issued.
For example, if the interest rate of newly issued bonds is greater than that of older bonds, then these new bonds are more appealing to investors.
This has the effect of lowering the value of the older bond if the investor decided to refinance to the newer bond that pays a higher interest rate.
As a general rule, the value of older bonds tends to move in the opposite direction to the movement in interest rates of new bonds issued.
Be careful – the value of bonds move
in the opposite direction to its yield
The value of bonds can also be affected by the confidence bond investors have in the bond issuer.
For example, a company that issued corporate bonds may now be showing an increase in its profits which strengthens its financial position.
This new financial strength may increase the confidence bond investors have that this company will meet all of its interest rate payments, with the effect that bond investors may pay more for this bond for the added security.
The effect on investor confidence can also occur with municipal bonds.
If bond investors are concerned about the government's ability to meet its interest payments, they will probably pay less for the bonds thus lowering the bonds value.
In general, the price movement of bonds is fairly minimal compared to the price trends exhibited by stocks and are considered a safe haven investment for a portfolio.
While stocks are more volatile than bonds, in the long term stocks considerably outperform bonds.
Benefits and Risks of Bonds
Be aware that bonds are not guaranteed
Bonds are fairly Safe
Bonds are generally considered to a fairly safe investment and tend to be popular with investors who are fairly conservative with their risk profile.
The interest payment that the bond investor will receive for the duration of the bond is known in advance.
Also, the capital that will be returned at maturity is known in advance, it's simply the face value of the bond (which is not necessarily the price paid for the bond).
Risks with Bonds
Bonds are not guaranteed and there are some risks with bonds that the bond investor needs to be aware of and these are outlined below:
Risks with Bonds:
- Interest payment risk: Bond investors are relying on the bond issuer's ability to continuingly make the interest payments up to the maturity date (some long-term bonds having maturities of 30 years and more).
- Capital repayment risk: Bond investors are again relying on the bond issuer's ability to actually repay the face value of the bond at maturity.
- Bankruptcy risk: Corporate bonds are issued by companies and there is always the risk that at some future date the company may wind up in bankruptcy.
- Bond recall risk: The bond issuer may terminate a bond prior to its maturity date. This can occur if interest rates decline and the bond issuer effectively refinances their higher interest paying bonds with new bonds issued at a lower interest rate.
- Inflation risk: The face value of most bonds are not adjusted for inflation which is not much of an issue with short-term bonds. However with long-term bonds which can have maturities of over 30 years, inflation has a significant effect on the returns obtained from bonds.
- Liquidity risk: After a bond is issued they can be sold to a bond dealer on the over-the-counter (OTC) market. Some bonds are popular and are easily sold to a bond dealer. A bond dealer will only buy a bond from an investor if they can easily sell it to another investor. Thus there is the risk that if the bond investor decided to sell their bond, they can not sell it a bond dealer.
- Resale value risk: The value of a bond is based on the time remaining till maturity and on the current interest rate environment. If interest rates rise after the bonds issue, then newly issued bonds will be more appealing to bond investors, thus lowering demand and hence value of the older lower interest rate bonds.
While the risks from investing in bonds are relatively low, the bond investor still needs to be aware that they are not risk-free.
The lowest risk bonds are treasury bonds, followed by municipal bonds and then corporate bonds.
For bonds issued at the same time with the same maturity, treasury bonds will typically have the lowest interest rates and corporate bonds will have the highest interest rates.
Bonds vs. Stocks
Each have their own benefits and risks
The long-term total return from stocks significantly outperforms that obtained from bonds. In the short-term stocks are considerably more volatile than bonds.
Bonds and stocks have different characteristics for both yield and capital gains.
With bonds, the yield is a fixed amount based on the price paid for the bond (excluding inflation adjusted bonds).
The interest amount paid is the same year after year and is known in advance. These payments will continue as long as the bond issuer is able and willing to finance its payment obligations.
For stocks that pay a dividend, the yield is similarly based on the amount paid for the stock, however the yield is not known in advance as the dividend payment is not known until a dividend is declared.
These dividends typically vary depending on the company's financial position and there is no guarantee that a dividend will be continuously paid into the future. In general, the dividends increase over the long-term in line with growth in the company's profits.
For stocks that do not pay a dividend, there is no yield as there is no income the investor receives.
Thus, for bonds the yield is fixed and known in advance, whereas for stocks that pay dividends, the yield is variable but generally increases over the long term.
Stocks exhibit capital growth over the long-term in line with the growth in the company's profits and its assets. This means that the value of companies in 30 years time is more than it is today.
Bonds do not exhibit a true capital gain as occurs with stocks.
This is because there is no capital growth in a loan (which is what a bond is). The exception is inflation adjusted treasury bonds where there is at least the growth from inflation.
So for a typical 30 year bond, the face value remains static. This means that in 30 years time the investor merely receives back the original face value.
Therefore the total return from a 30 year bond held for 30 years is simply the interest rate yield (since there is no capital gain).
The capital gains from bonds works
differently to that of stocks
While holding a bond from issue date to maturity provides zero capital gain, the value of bonds are very sensitive to the current interest rate environment.
This means that during the life of a bond, its value varies.
This variation in value fluctuates along with the interest rate cycle.
This is not a capital growth as such, since the interest rates themselves only cycle between high and low rather than continuously head in one direction.
These cycles do however provide investors with times where buying bonds will be more profitable.
Buying a bond when its value is less than its face value will actually provide a capital gain on the investors purchase even though the face value has not changed.
A newly issued bond held till maturity does not have any capital growth as it is merely a loan, but savvy bond investors can use bond strategies that provide some capital gain - such as purchasing bonds for less than their face value.
This potential capital gain is quite limited, but it is generally low risk.