Bonds

TLDR

A bond is like borrowing money from someone and promising to pay it back later with interest. It's a debt security that allows an investor to lend money to an organization or government in exchange for regular interest payments and the return of principal at maturity.

What Is a Bond and What Is Their Purpose?

Governments and corporations issue bonds when they need to raise money. You are basically lending the issuer money when you buy a bond. In return, they agree to pay you the whole amount of the loan on a specific date as well as regular interest payments (usually twice a year) during the repayment period. Bonds issued by firms do not provide ownership rights, in contrast to stocks. You won't necessarily benefit from the business's development, but you won't notice as much of an impact when the company isn't doing as well either, as long as the company still has the ability to make loan payments on time and doesn't default.

This means that if you include bonds in your portfolio, you may benefit from two things: first, they give you a reliable source of income, and second, they serve to lessen some of the volatility associated with stock ownership.

Types of Bonds

The four main types of bonds are listed below. However, it is important to know that certain platforms may also feature international bonds issued by governments and multinational enterprises.

Corporate Bonds. They are issued by businesses and in many circumstances, they choose to issue bonds rather than apply for bank loans for debt financing since the bond markets provide better conditions with cheaper interest rates.

Government Bonds. A type of investment security issued by a government, like the U.S. Treasury. These bonds come in various types, each named based on their maturity date. Treasury bills are government bonds with a maturity of less than a year and unlike other bonds, they don't pay interest but are issued at a discounted price and can be bought back at the face value on maturity. Treasury notes have maturities of 2 - 10 years, Treasury bonds have maturities over 10 years, mostly 30 years, and Treasury Inflation-Protected Securities (TIPS) are bonds that have returns linked to inflation.

Agency Bonds. Debt securities issued by government-sponsored entities such as Fannie Mae, and Freddie Mac, or federal agencies, like Small Business Administration. These bonds are guaranteed by the US government and considered as having similar creditworthiness as US Treasury bonds.

Municipal Bonds. A debt security issued by state and local governments to finance public projects such as infrastructure. They are considered lower risk and tax-free for buyers who reside in the same state where the bond was issued.

Bond Characteristics

• Face value, also known as the par value, is the amount of money a bond will be worth at maturity and the reference point for calculating interest payments.

• The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.

• The coupon dates are the dates on which the bond issuer will make interest payments. Payments are typically made semiannually.

• The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.

• The issue price is the price at which the bond issuer originally sells the bonds. This is usually at par.

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Specifically for corporate bonds, just like an individual's creditworthiness is assessed before getting a car loan, companies must undergo a credit evaluation by a rating agency before issuing bonds to investors. Bond rating agencies such as Fitch, Moody's, and Standard & Poor's are responsible for evaluating the financial strength of corporations and determining their creditworthiness. They assess the likelihood of a company meeting its financial obligations on time and assign a letter grade accordingly. These grades fall into two main categories: investment grade and non-investment grade. Investment-grade bonds are considered to be of higher quality and have a lower risk of not paying bondholders on time. Non-investment-grade bonds, also known as high-yield or "junk" bonds, are riskier and have a higher chance of default. Such bonds usually offer higher coupon rates to compensate investors for the added risk. The highest grade is a "triple-A" rating, indicating that a bond is the most likely to meet its debt obligations and the lowest risk. Ratings decrease as the perceived quality of the bond and the level of risk decrease.

Common Bond Variants

• Zero-Coupon
  

  Z-bonds are a type of bond that doesn't give you money back during the time you have it. Instead, when the bond ends, you will get more money than you bought it for. U.S Treasury bills are a special kind of Z-bond.

• Convertible
  

  Convertible bonds are a type of loan that a company can borrow, but with an added bonus. These bonds give the person who bought them the chance to turn the loan into company shares later on if the company's stock price goes up enough. This is good for the company because it typically saves them money on interest, which can be distributed at lower rates using this variant. But, if the people who bought the bonds change them into shares, it will make the company's shares worth less for the other shareholders. The people who bought the bonds take on more risk because they get less interest, however, if the company does well they can make more money from the shares they get. This can be a win-win solution for both the company and the bond investor.

• Callable
  

  Callable bonds are like regular bonds but can be taken back by the company before maturity. This is riskier for the bondholder, as it's more likely to be called back when it has more value due to declining interest rates which makes bond prices rise. Callable bonds are less valuable than bonds that cannot be called back and have the same credit rating, maturity, and interest rate.

• Puttable
  

  Puttable bonds are like regular bonds, but they allow the person who bought them to give them back to the company before they end. This is helpful for investors who think the bond might lose value, or if they think interest rates will go up and they want to get their money back before the bond becomes less valuable. The bond issuer may include this option in the bond to benefit the bondholders in return for a lower interest rate. Such bonds usually cost more than a bond without this option but with the same credit rating, maturity, and interest rate.

Bond trading

Bonds are like loans with set interest payments and maturity dates. Their prices change based on the supply and demand in the market, and they also depend on the interest rate of the economy. When interest rates go up, new bonds with higher interest payments are issued, making older bonds less valuable and their prices decrease. And when interest rates go down, older bonds with fixed interest payments become more attractive and their prices increase. Investors in the market determine the bond's price until it matches the current interest rate environment and this is known as interest rate risk. The bond's price adjusts to match the current interest rate environment which is known as the interest rate risk.

Stocks vs Bonds

Stocks have historically performed better over a long period of time. According to investment researcher Morningstar, large stocks have on average returned a 10% per year return since 1926, while long-term government bonds have returned a range of 5 - 6% over the same period. I'll quickly summarize this argument with a visual below:

Where to buy

If you are inclined to utilize bonds in your investing strategy, many options can be found on the TreasuryDirect website.

However regarding the buying and selling of corporate bonds, this mainly occurs in the secondary market, sometimes referred to as the over-the-counter (OTC) market. This means that in order to trade corporate bonds, investors must do it through a broker or dealer. Another option is to purchase bonds through an exchange-traded fund (ETF) that combines the ownership of many corporations' bonds. Bonds having certain maturities, credit ratings, or market sector exposure may be the focal point of various funds. Investing in the already diversified corporate bond market through an ETF may be done for a lot less money than buying individual bonds would.

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