Bond Basics
Bonds are an essential but often less-understood asset in many portfolios. In the simplest form, a bond is a debt agreement between an issuer and the bondholder (lender). The agreement includes features like the interest paid for using the funds and when the borrowed amount (principal) will be repaid. Generally speaking, the more risky the bond issuer is, the more they must pay in interest to attract lenders. In many cases, more interest is required to attract investment in long-term bonds, because the money the bond holder provided to buy the bond won’t be repaid for a longer time.
Think of it in basic terms – if you were to have an extra $1,000 to lend and your choices were the U.S. Government and some random guy you met looking to develop some oceanfront property in Arizona, which would you choose? The U.S. government has never defaulted (not paid) a bond or interest payment – and your new buddy… is less of a sure thing. Logic would hold that your buddy should pay you quite a bit more in interest for using your money, especially if he doesn’t intend to pay it back for ten years when he sells the property for a handsome profit. Lending to the government probably won’t produce as much interest, but there’s a LOT less risk to it.
It is also straightforward to think of buying a bond, collecting interest, and holding it to maturity when you receive your money back. The math is relatively simple to know how much you’ll be paid over the life of the bond (nominal interest rate) and even the present value of that income stream so that you can compare it to other investment opportunities. Many successful investors have created a secure income stream by setting up a “bond ladder” in which they hold many bonds with varying payment & maturity dates that meet their regular income, time horizon, and risk objectives.
In many cases, bondholders choose not to hold the bond to maturity and instead sell it to another investor. The sale transaction itself is straightforward, similar to a stock. However, pricing the bond is a bit more tricky. That is, in large part, due to changes in interest rates in the broader bond market. If interest rates go up on similar bonds to the one being sold, it wouldn’t make sense to pay more for the existing bond and income stream than it would cost to buy a newly issued bond. Therefore, the price of the existing bond goes down as interest rates go up. The nominal interest on the bond remains the same as when it was issued, but the yield relative to the new lower price increases to make the existing bond market relevant with the newly issued bonds. To complicate matters a bit more, the amount of price change depends on terms of the bond – especially its time to maturity. After all, if you held a 10-year bond for 8 years and wanted to sell it, not many interest payments remain before the bond matures and the principal is paid. The longer the bond is away from maturing, the more the change in interest rates will affect the market pricing of a bond. By the way – this works in reverse too. If prevailing interest rates go lower, the existing bond prices move higher.
The goal of this article is not to get into the details of exactly how to value that bond. There are valuation models and math behind the scenes that help with that, and markets are generally very good at determining the current fair price of a security given the information known at any given time.
Investors can purchase individual bonds to build bond ladders, bond bullets, bond barbells, etc. Ack! An easier way to invest in bonds is to use an ETF or Mutual Fund that holds the bonds and distributes the income regularly. Of course, you have to pay the fund manager because nobody works for free, but it is much, much easier to use. The other consideration for using a fund is to the ability to hold a diverse portfolio of bonds in one investment.
One of the biggest risks of lending money is not getting paid back – a default. Using a fund that holds multiple bonds reduces the impact if one of the bonds does end up in default. It is much easier to hold a diverse bond portfolio using a fund than to build a portfolio with individually selected securities. Further, bond funds also are managed to objectives like risk, term, and tax consequences that can help investors hold funds that are most suitable for their needs.
All of that said, why would an investor use bonds? As mentioned above, bonds are a great tool to generate income. Furthermore, debt (bonds) is often less risky than equity (stock). That’s because if a company fails, bondholders are more likely to get something from the company than an equity holder whose value often goes to zero. Furthermore, capital often shifts to the safety of high-quality bonds when economic risk is high. Rather than ride out a storm in equities or high yield “junk” bonds, many investors and institutions prefer the relative stability and income of very low risk bonds. Also, monetary policy often changes when risk is high and interest rates are reduced. Remember – that means that bond prices go up!
There are no guarantees in markets, but a fundamental truth is that there is no free lunch, and securities with more risk generally pay a premium (or the possibility of a premium!) to attract investment. The amount of risk and reward varies in the economy and through the business cycle, so it’s important to understand how securities like bonds work and the role they might play in a diversified portfolio.