Financial Literacy – Bonds

What are bonds? Bonds are debt instruments, usually offered by a government, corporation, or municipality, that promises to pay back the principal amount plus interest over the term of the agreement. Since the lenders have a seniority claim to debts, meaning if the company goes out of business you’ll get paid first over shareholders, it offers a lower rate of return compared to other financial assets as it is seen as safer. Additionally, the probability that a government or municipality will default on their debt is lower than a corporation and returns are reflected by this fact. Government treasuries (bonds) are seen as the safest financial investment a person can make, the reason is because the likelihood of the government not being to pay its debts is almost non existent. The government, alongside the Federal Reserve, would likely just print money to pay debts. Municipalities are riskier and have defaulted on debts before. Corporations are the riskiest of the three and have the highest potential returns in terms of bonds.

There are many different types of bonds and they all have different benefits and negatives. Government Bills, which are U.S. government bonds that are one year or shorter, do not pay a coupon rate. Instead you purchase the bond with a discount on its face value. The gain at maturity is the effective coupon rate. For example, you may purchase a $1000 bond for $950, meaning that you gain $50 at maturity, representing a 5% yield or coupon rate. Some bonds also offer tax advantages, and an example is a government treasury being exempt from Federal taxes. You may still pay state and county taxes, but not Federal. Municipal bonds offer similar benefits, some being exempt from Federal, state, and county taxes, making those returns tax exempt. Some bonds, called convertible bonds, offer stock options as a potential form of payment, making them unique and potentially lucrative. Additionally, bonds can also be “callable” or “uncallable”. This means that a bond can be redeemed by the borrower early. This may be exercised by a borrower if interest rates fall, making paying a bond with a higher rate to you more expensive than simply refinancing. Callable bonds usually offer higher rates of return because of this feature, as most who buy bonds want a predetermined rate of return and duration.

Bonds are rated, much like you and I, in terms of credit worthiness. AAA is the highest and safest credit grade and goes down letters to reflect tiers, the next one being AA. After a bond gets to A-, it drops to BBB. BBB- is the lowest investment grade bond rating and lower than this is considered “junk” bonds. These bonds are risky and defaults can happen, meaning youll lose your principal but these bonds offer higher rates of return to compensate over safer alternatives.

The way bonds work is that they have a “face” value, also called “par” value and offer a coupon rate, which is the interest youll earn over the course of the duration of the bond. Every 6 months (usually) you will receive an interest payment. This will continue until the bond matures, or comes to the end of the loan term and at that date your principal will be returned. Interest rates (Federal Funds Rate) affect the rate of return and ,generall, the longer the duration, the higher the return. It is possible to sell bonds before maturity, meaning if interest rates go up after you have bought your bond, you will have lost money if you sell the bond before maturity. The reason this happens is because if there are bonds out there with a higher rate of return, the demand for your bonds goes down. To compensate, you will have to lower the face value of your bond until the rate of return matches the prevailing interest rates. For example, consider if you have a $1000 bond with a 5% yield ($1000 * 5% = $50) and all of a sudden interest rates go up to 6% ($1000 * 6% = $60) . Not many will want 5%($50) when they could get a newly issued bond that yields 6% ($60). So what you would have to do is match the 6% interest rate($60), but since the 5% rate of return ($50) is fixed, the only way to match the new rate is to lower the face value ($60 / 5% = $833.33), making the new face value ($833.33) lower than your original face value ($1000). The opposite could also happen where your old bond is higher yielding than new issues and you could realize a gain. The longer the duration, the more interest rates affect the price of a bond, with some bonds maturing over 30 years being extremely sensitive to changes in rates. This means that just a 1% change in interest rates could have a huge change in prices. Generally though, it is not advised to prematurely sell bonds unless this gain is the intention, just realize that this is how many people lose money in bonds, as if you would just hold your bond to maturity, you would get your principal back. Inflation must also be closely watched, because it is entirely possible to have a rate of return that is lower than inflation, meaning that while you are earning money it is losing purchasing power and so you are actually realizing a negative return.

The primary reason investors want bonds is because of perceived risk. If things look shaky in the stock market and stocks look risky, investors will seek safer investments. Another reason investors want bonds is because they are nearing the end of their investment careers. Since, in the short term, stocks are generally volatile (swing up and down rapidly), some investors nearing retirement may choose to invest in bonds to protect their principal while enjoying a predictable fixed income. They know exactly how much interest they are earning and can rely on and exactly when the bond matures and they get their principal back. This is the reason that financial advice generally says that the closer you get to retirement, the higher the percentage of bonds should be in your portfolio. Could you imagine having JUST enough money to retire, having one more year before retirement and over that year the value of your portfolio dropping 10, 15, or maybe even 25%? Markets move in cycles, things dont go up forever and these corrections are a natural part of any business and economic cycle. The value of bonds to a portfolio is not generally their ability to generate high returns, but rather to smooth out the volatile swings of the markets. Since bonds offer safer alternatives to the markets, it is wise to understand this mechanism and its value to an investor.

This is going to conclude the topic of bonds. This is generally the knowledge you need to understand why and how bonds function and also why you may want to own them even if their historical returns are less than stellar. Understanding this topic will also allow you to understand how the markets are doing in future lessons, understanding why bond yields may be high or low and what that means in the markets and for you specifically.

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