Bonds and other fixed income investments are generally recommended by financial experts as part of a diversified portfolio. Learn the basics of fixed income.
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Key points to remember
- A bond is essentially a loan from a bond investor to the issuer
- The bond issuer can be the government (treasury bills), a state or local municipality (municipal bonds), or a corporation (corporate bonds)
- Although bonds are often considered less risky than stocks, there are risks associated with bonds.
Cookies and milk. Hansel and Gretel. Stocks and bonds. Some things seem to go together. But as familiar as the phrase “stocks and bonds” may be, the truth is that many investors don’t know what bonds are and how they work. This could make some people hesitate to invest in bonds.
Perhaps the bullying stems from the fact that bonds are often referred to as fixed income or “debt instrument,” two terms that average investors may not be familiar with. So let’s describe bond investing with an easier to understand and simpler term – a loan from the bond investor to the issuer. It is a simplified definition of obligations.
What is a link?
Bonds are a type of fixed income security in which an issuer (or borrower) is required to make periodic payments of a specific amount or rate at regular intervals.
Government entities, from the US Treasury to state and local municipalities, must raise funds – whether for specific projects or just to fund basic services. Companies often choose to finance acquisitions by debt, modernize their factories or technology, etc. So they issue bonds. Bonds generally consist of three elements:
- Main. This is the face value of the bond, or the amount an investor initially pays to buy it. The principal amount (also called “through” or “nominal value”) Is generally set at $ 100 or $ 1,000 per bond.
- Maturity. This is the date when the loaned money – the principal – must be repaid. For example, a standard US Treasury bond has a maturity of 30 years.
- Interest rate. This is the annual amount, expressed as a percentage, that the bond issuer must pay to the acquirer over the life of the bond. The rate is also known as “couponAnd that’s where the term “clipping coupons” comes from. Even though the interest rate is expressed in annual terms, many bonds make coupon payments twice a year.
Reliable income is subject to the credit risk of the bond issuer. If an Issuer defaults, no future income payment will be made.
Bonds tend to be viewed as a more stable and predictable form of investment than the stock market. Bonds can help you weather the volatility that the stock market tends to offer, no matter which direction the market might take.
Like stocks, bonds can operate in cycles, but they are generally less volatile. Bonds sometimes outperform stocks in a down market, potentially offering a measure of diversification for investors trying to build more balanced portfolios. And like stocks, they carry an element of risk, so investors should carefully research a bond and its risk before investing.
How do bonds work?
Here is an example scenario to illustrate how a bond investment works:
- Investor Anne purchases an XYZ Corporate Bond with a principal (or face value) of $ 1,000, an interest rate (coupon) of 5% and a maturity of 10 years.
- Annually, XYZ pays Anne $ 50, or 5% of the bond’s $ 1,000 face value.
- After 10 years, Anne has collected a total of $ 500 in interest payments and XYZ buys the bond back from her at face value of $ 1,000.
In this example, investor Anne used the purchase of bonds to preserve capital – the initial investment of $ 1,000 – while creating an annual cash flow, annual payments of $ 50. This is essentially how bonds work.
What are zero coupon bonds?
Some bonds will repay the principal at maturity but will not make coupon payments along the way. To compensate the investor, these so called “zero coupon bonds” are usually sold at a discount to their face value. So, for example, you can buy a zero coupon bond with a face value of $ 1,000 for $ 800 and, at maturity, you will receive the face value of $ 1,000. Depending on the term to maturity, this discounted amount can be used to calculate an effective yield to maturity.
How Interest Rates Affect Bonds
But what if our hypothetical investor wanted to sell his bond before the maturity date? In this case, things can get a bit more complicated.
The interest rate of a bond at the time of issuance is affected by two factors: current interest rates and the risk of issuer default. This rate is fixed for the life of the bond. Putting the risk of default aside for now, assume that investor Anne bought a 10-year bond in a low interest rate climate, but when she wanted to sell it five years later, the rates interest had increased dramatically.
In this case, investors could buy newly issued bonds with higher rates than that sold by Anne and thus earn a better return on their capital. For this reason, Anne’s bond would trade at a haircut, also known as “below par trading”. This reduction allows a buyer of Anne’s bond to realize a return on capital similar to what the buyer bought a newly issued bond with a higher interest rate. Remember: regardless of where the bond is bought or sold, at maturity the owner of the bond will receive the face value of $ 1,000.
Here is a very simplified illustration of the discount:
Link A: A $ 1,000 bond issued five years ago with a 3% coupon would generate $ 30 in interest per year.
Obligation B: A $ 1,000 bond issued today with a 4% coupon would generate $ 40 in interest per year.
Bond A should be reduced to around $ 950 to be competitive with current bonds ($ 30 / $ 950 = 4%).
Again, this is a very simplified example of how interest rates can affect bond prices, but it illustrates the underlying concept. If the numbers were reversed and Bond B had a lower interest rate than Bond A, Bond A could trade at a premium to its face value.
Risks associated with bonds
As mentioned, risk also plays a role in setting the coupon rate of a bond. Government bonds tend to be less risky than corporate bonds and therefore will generally have a lower interest rate. But there can be different rates even among corporate bonds. This is due to what is called the risk of default.
Default risk is the estimated risk that an issuer will go out of business and not be able to repay the principal – and remaining interest – on the bonds it has issued. The riskier the issuer, the higher the interest rate it will offer on its bonds. Governments and municipalities, as a rule, seldom default on their obligations. However, there were times when they temporarily fell into default.
Much of the risk involved in buying bonds can be mitigated by buying only those that are highly rated. Various agencies like Moody’s and Standard & Poor’s issue, monitor and update bond ratings on a regular basis, but they each have their own rating criteria, so investors should educate themselves about the risks and ratings of bonds.
Having said that, the bond market is quite robust. Millions of bonds and other fixed income securities are bought and sold every day in the secondary market (i.e. after the initial issuance). This includes treasury securities and corporate bonds of different maturities. Bond dealers and traders provide liquidity to the bond market by posting offers and bids on bonds based on their relative yields and maturities, adjusted for the relative risk of each bond. This is called bond arbitrage (or fixed income arbitrage) and it’s part of what keeps bond prices in line.
Conclusion on bond investment
Assuming there is no default or other credit event, bonds can provide a steady stream of income and act as a potential anchor for diversification in a portfolio. A portfolio with a strong focus on equities could benefit from an allocation to bonds. But individual bonds can pose unique risks and therefore may not be suitable for all investors. Bond funds can spread risk across many securities, but investing in funds comes with its own set of risks, fees and tax implications.
In other words, as with all investments, it’s important to do your homework before you get started.
Investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds generally fall in price when interest rates rise and rise when interest rates rise. interest fall), financial (or credit) risk, inflation (or purchase). power) and special tax obligations. May be worth less than the original cost when redeemed.