In investing, there are three primary asset classes: cash, stocks, and bonds.
Cash is self-explanatory, and most of us have at least a basic understanding of stocks. A stock is simply a fractional ownership interest in a company.
But what about bonds? These investments are vital to our economy and equally important to most investors’ portfolios. But what is a bond, exactly? And when should you invest in bonds?
What is a bond?
A bond is a loan to somebody (a corporation or government) with a fixed interest rate over a fixed period of time. Bonds are called “fixed-income” securities because they pay a fixed return (coupon) based on the interest rate. Most bonds distribute earnings every six months.
Companies and municipalities use bonds to finance everything from real estate to machinery to routine operating costs. Buying a bond is akin to lending company money and they will pay you back later with interest.
Why buy bonds?
Two reasons: First, the consistent income bonds provide is useful when you’re living off of your investments (as in retirement).
Second, many bonds (but not all) are considered lower-risk investments than stocks. For this reason, investors use bonds to minimize the volatility inherent with investing in the stock market. Theoretically, when you own a larger percentage of bonds than stocks, you should experience smaller swings in your portfolio’s value.
For young investors, bonds shouldn’t be used a lower-risk replacement for stocks but as a less-volatile complement a portfolio of stocks.
Bond types and credit ratings
Not all bonds are created equal. There are bonds issued to corporations (corporate bonds), municipalities (municipal bonds) and even the federal government (Treasury bonds or Treasuries). The savings bonds your grandparents may have given you as a child are a form of Treasury bond.
In addition, each bond is given a credit rating that affects the amount of interest they’ll need to pay to attract investors. This is no different than the way someone with an excellent credit score gets a low auto loan rate while someone with a lesser score pays a higher rate.
Investment-grade bonds are rated AAA (high quality) to BBB (medium quality). Issuers with a credit rating of BB or lower are known as “junk” bonds. Credit ratings change, so before buying a bond you must research to see if the company has a history of declining creditworthiness so that you aren’t taken by surprise if the bond’s credit rating falls from investment-grade to junk status.
What to know about bonds you buy
There are a few things you’ll need to know before buying a bond.
The first is the maturity date, or the date on which the issuer pays back your loan in full. This date can range quite a bit, but typically averages between 3 and 10 years. In exchange for lending the company funds, the bond pays out interest (the coupon rate). These interest payments are generally made on a semi-annual basis, but it’s not unheard of to see annual, quarterly, or even monthly payments.
Bonds may be issued as either secured or unsecured. Secured bonds are backed by physical assets which revert to the bondholder if the company cannot honor its obligations.
Unsecured bonds are called debentures and are backed only by the faith and credit of the issuer making them more risky than secured bonds. If a company does claim bankruptcy, bondholders are given priority over stockholders to any recovered funds.
You may notice that bonds trade above and below their par value. As a hypothetical example, if you’re buying a $1,000 ACME Corporation bond, you might see that bond on the market for $980 one month but a few months later it’s risen to $1,050. What’s going on?
Bond prices move inversely with prevailing interest rates.
- When interest rates go up, bonds with lower interest rates will trade at a discount because investors can now buy other bonds at higher rates.
- When interest rates go down, bonds with higher interests will command a premium because they pay a better rate.
With a few exceptions, the stock market and bond market are inversely correlated; as one rises, the other falls.
Risks of bond investing
Risks to bondholders include the possibility of default, prepayment risk if the bond is called, and interest rate risk.
Obviously, if a bond goes into default, investors may lose some or all of their principal. Although rare with investment-grade bonds, it’s always a possibility.
Second, bonds may be issued with provisions like a call option. These bonds may be called back by the issuer if rates go down allowing the company to save money by refinancing its own debt. Because these bonds might be called, they will be offered at a premium to attract investors.
Lastly, if interest rates rise when you already own a bond, you may miss out on the opportunity to buy the same bond for a higher rate of return. When this happens, the price of the bond will fall. Ultimately, this has little effect on you if you intend to hold the bond until maturity, although you will be earning less interest until it matures.
As a beginning investor, you’ll most likely be investing in bonds as part of a bond mutual fund or bond exchange-traded fund.
These funds own hundreds of bonds. Like individual bonds, these funds values have an inverse relationship with prevailing interest rates; as interest rates rise, bond fund prices fall. Bond funds provide some insulation against rising rates, however, because when a bond the fund owns matures, it buys new ones at today’s interest rates.