How do bonds work?

Bonds are a popular form of investing, as well as a commonly-employed means of raising funds for government, corporate, and municipal projects. Depending on your goals, bonds can play a useful role in your investment portfolio.

What is a bond?

A bond is a type of loan issued by a government or corporate entity. The loan is short-term, and investors make money by collecting a portion of the interest. The maturity date is the date by which the bond value of the bond must be paid back. In most but not all cases, the bond ceases to exist once it reaches maturity.

What is the relationship between bonds and interest rates?

An interest rate is a predetermined fee that’s applied to a loan in order to finance the operations of the lender. Collecting interest on your bond is one of the two most common ways that bonds can be used to generate income.

Holding bonds vs. trading bonds

Another common to make money off a bond is by selling it. Bonds can be traded, and their value fluctuates just like any other investment opportunity. If you intend to trade the bonds you buy, then you should research the bond to see how susceptible the bond is to market volatility. That’s because its value when traded will not necessarily be the value it had when you bought it. Instead, the bond’s value is set by the market.

How to evaluate bonds

Bonds may be less risky than stocks, but they’re not risk-free. If your bond defaults, then you’re losing out. How do you pick the right bond, then? By consulting bond ratings. The bond score is issued by the entity that originates the bond. The three major players are Fitch, Moody’s, and Standard & Poors.

Fitch and Standard & Poor’s use a similar scoring system:

  • AAA
  • AA
  • A
  • BBB
  • BB
  • B
  • CCC
  • CC
  • C
  • D

Moody’s has a slightly different system:

  • Aaa
  • Aa
  • A
  • Baa
  • Ba
  • B
  • Caa
  • Ca
  • C

The rating systems get even more granular. Fitch and Standard and Poor use a system of pluses and minuses to communicate quality. A+ is better than A, and A is better than A-. Moody’s uses numbers to accomplish this task. Aa1 is better than Aa2, and Aa2 is better than Aa3.

A bond with a higher rating is safer, but its return on investment is lower for that exact reason. A bond with a lower rating has a greater return on investment as compensation for taking on additional risk. There’s even such a thing known as a junk bond, which is a bond with a rating system of BBB- or Baa3. A junk bond may not be investment-grade, but it does have the potential to carry a greater return on investment. Bond ratings aren’t static, so it’s a good idea to research a bond’s history and keep tabs on its ongoing performance.

What are common bond terms?

Bonds are common enough of an investment that jargon has emerged just for the purpose of talking about bonds. This technical language may appear alienating to the uninitiated, but once you know how to use the words you’ll be able to easily digest the information you need to make informed decisions.

Coupon

A bond’s coupon is the interest rate the bond pays out. It’s unlikely to change once the bond is issued.

Yield

A bond’s yield is what you get when you divide the bond’s coupon by the bond’s changes in value.

Face Value

This is the bond’s value when it’s issued, AKA its “par” value. The most common face value you’ll encounter for a bond is $1,000.

Price

A bond’s price is how much it would fetch if it were traded on a secondary market. There are several factors that determine the bond’s price, with perhaps the most important being what the bond’s coupon is relative to other, comparable bonds.

Maturity

Maturity indicates how long it will take for you to earn back the bond’s face value. Most, but not all, bonds cease to exist when they reach their maturity.

Callability

Callability is the option for some bonds to be paid off prior to maturity. If the bond is paid off before reaching maturity, that usually means the bondholder will get some extra money.

Put provisions

A put provision is an opportunity that some bonds have to be sold back to the bond issuer at a certain date before the bond reaches maturity.

Convertible bonds

A convertible bond is a bond that can be turned into a certain number of shares of common stock in the company that issued the bond or in exchange for equal cash value.

Secured bonds

A secured bond is backed by a particular type of collateral. In the event of a default, that asset is divided between bondholders.

Unsecured Bonds

An unsecured bond is not backed by any asset. It gets its worth from the credibility of the bond issuer.

What are bond yields?

A bond’s yield is how you measure its return. While a bond’s yield to maturity is the most frequently employed measurement, there are a few other techniques employed for different situations.

Yield to Maturity (YTM)

The YTM measures the return of the bond if you keep it until maturity and then has its interest reinvested. Since the interest will be paid out at various points, it’s unlikely that the interest will be reinvested all at once. This means that the return on investment won’t be 100% aligned with its face value. Calculating the YTM can be time-consuming, so its best to use either spreadsheet software or a financial calculator to do the work for you.

Current yield

If you wanted to compare the interest paid out by a bond to the dividends paid out by stock you could calculate the current yield. This is done by dividing the interest paid out by the bond by its current price. This figure only calculates the interest and not any gains or losses that the bond may have experienced, so it’s only really useful for people who want to know the income generated by the bond right now.

Nominal yield

If you divide the bond’s annual interest payout by its face value you get its nominal yield. That’s the amount of interest that’s paid out periodically. Unless the current bond price and its face value are the same, you’re not going to get an accurate estimate of the return. For this reason, the nominal yield is only really used as parts of other measures of return.

Yield to Call (YTC)

If you’re holding a callable bond, then you’re going to want to know what your return on investment is going to be at various points in the future given that the bond may be paid off before it reaches maturity. This is yet another measure that’s best calculated using spreadsheet software or a financial calculator.

Realized yield

The realized yield is an estimate of the bond’s future price. This is calculated when the bond holder intends to sell the bond before it reaches maturity. Realized yield is an estimate at best, but it’s useful nonetheless. The best way to calculate the realized yield is by using spreadsheet software or a financial calculator.

What are the benefits of bonds?

Bonds are typically low-risk investments that come with the added benefit, in the case of government or municipal bonds, of helping public goods and services come to fruition. In the case of junk bonds, you can also get a greater return on investment as compensation for taking on a greater risk, which means you could be helping an important yet uncertain venture achieve realization, if that’s of concern for you. Tangentially, keeping track of bonds is also important because an inverted yield rate, which is what happens when short term government bonds deliver a better return than long term government bonds, is often a precursor to a recession.

What are the drawbacks of bonds?

Bonds are considered to be a generally safe investment, but they don’t come without their pitfalls. Here are just a few.

Credit risk

Credit risk is the chance that the contract governing your agreement will be fully met by the predetermined date. Credit risk is most often discerned by appeal to credit ratings. The higher the rating the lower the risk and the lower the return. Bonds are divided into two general categories: investment-grade and junk. Their names speak for themselves.

Inflation risk

When it comes to bonds, you always run the risk that monetary policy will lead to systemic inflation, which is what happens when the purchasing power of currency goes down relative to the cost of goods and services. Unless you have a variable rate bond or a bond with built-in protection, your investment might be undone by inflation.

Liquidity risk

Liquidity is a measure of an investment’s capacity for being turned into cash without significantly eating into the face-value of the investment. Bonds tend to have less liquidity than many other forms of investment, so you might want to limit the percentage of your investment portfolio that’s comprised of bonds.

Reinvestment risk

Reinvestment risk describes the possibility of the facts on the ground changing unfavorably by the time your bond reaches maturity.

What are the common types of bonds?

Government bonds

These are bonds issued by sovereign governments. They are backed by the full faith and credit of the issuing country, which can take whatever steps necessary to pay off the bond. Governments put out various different types of bonds to finance all sorts of endeavors. Even though government bonds are stable and, as a result, carry lower risk, they often deliver a significant return.

Municipal bonds

Also known as “muni bonds,” these are bonds put forth by localities to finance public projects or services. Muni bonds take one of two forms: general obligation or revenue. A general obligation bond is backed by the full fair and credit of the issuer. That means the locality can take whatever measures deemed fit to pay the bondholders on time. This may include taxes, selling assets, and the like.

Revenue bonds, meanwhile, are backed by the income generated by whatever project or service being funded. If, for example, the revenue bond is going toward maintaining a park, then a portion of the cost of admission may be used to pay off the bond. The interest paid out by both bonds is exempt from federal taxes, and if you invest in bonds issued by the state in which you reside, then you don’t have to pay state or local taxes either. The interest on municipal bonds tends to be less than comparable corporate bonds.

Corporate bonds

These are bonds put out by commercial undertakings such as corporations and LLCs. Corporate bonds offer high yields but are not favored by the tax code. Upwards of 40% to 50% from corporate bonds may end up going toward taxes.

Should you include bonds in your portfolio?

Bonds that are low risk can be a good investment for those who intend to hold them until they reach maturity or for someone whose near retirement, since that’s when you have lower risk tolerance. Although, there is the risk that the return on investment may not keep up with the rate of inflation if your bonds have too low of an interest rate.

When you’re earlier into your investment career, you can take a chance on some junk bonds since you’re likely to have enough time to recoup your losses. Another factor to consider is how important liquidity is to you. Bonds with low-interest rates may be harder to move since there’s less incentive given the lower return on investment. Meanwhile, junk bonds may be harder to move since the risk may be perceived to just not be worth it. However, you can offset the low liquidity of bonds by investing in multiple bonds that reach maturity at varying times as opposed to putting all of your money into a single bond.

Bottom line

Bonds are an indispensable tool for many governments, corporations, and municipalities. Whether they become an indispensable part of your portfolio depends on your investment goals, risk tolerance, portfolio diversity, how much you value liquidity, and how much money you have to invest. For this reason, there’s no one-size-fits-all answer to the question of whether or not bonds are right for you.

Pam Velazquez is Senior Marketing Manager at Public.com.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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