“Gentlemen prefer bonds.”Andrew Mellon
There are several types of investments that people can make today in including stocks, bonds, mutual funds, ETFs, and more. Today, we’re going to focus on bonds, which are one of the most commonly held investments in the world.
A bond is basically a “glorified loan” in which a company or any entity puts itself in debt to investors. It’s essentially a loan by the buyer to the seller. These companies sell their debt in portions called bonds. Investors who buy these bonds become bondholders. Investors buy bonds with an understanding the debtor, which is the entity issuing the bonds, will pay back their principal along with some interest to compensate them for buying bonds. Principal refers to the initial amount invested in a bond, and interest refers to the compensation that bondholders receive for holding the bond. Check out this article for more on interest and interest rates: Simple vs Compound Interest. There are different parts of a bond:
- Face value: The value of the bond when it’s issued (usually at $100 or $1000)
- Market value: The value of the bond on the market.
- Maturity: The date that the amount of debt has to be paid back along with interest
- Rate: The interest rate on the bond
- Coupon rate: the rate on the day the bond was issued
- Credit Risk: The risk of the issuer defaulting (stop paying)
Bonds are often known as a source of “fixed income” which is investment income that is often a set amount paid out on a set schedule. This means that bonds are often stable and low risk but offer a low reward because they’re much more stable than stocks. People usually buy bonds because they don’t want to “risk” their money in the stock market, which is riskier.
Bonds are issued by many different entities. The main four issuers of bonds are governments, corporations, municipalities, and private entities.
Government bonds are what they sound like: bonds issued by a government. The most popular government bonds are from the United States which are issued through the Treasury. There are three types that differ mainly in the length of the bond (1 year, 2-10 years, and 30 years).
They are considered a low-risk investment because the US government guarantees that the people who buy these bonds will eventually receive their principal along with some interest when their bond matures. A government bond is usually denoted by the country and the maturity rate. For example, the US 30 refers to the US government bond that matures in 30 years. When the yields on government bonds invert, investors take the inversion as a sign of an economic slowdown.
Companies issue bonds as an alternative to issuing more stock, which can dilute existing shareholders. While these are riskier than government bonds, you can determine the risk of the bond by looking at the credit rating of the bonds which are issued by S&P or Moody’s. For example, Tesla recently sold more bonds to help the company stay afloat amid its rapid cash burn. Cash burn refers to the rate at which a company uses cash to keep operations going. Their 8-year bond yields around 5.3% but they are risky since there’s no guarantee Tesla will be around by the time those bonds mature.
These bonds are issued by state, city, nonprofit, or district governments. They’re often used to fund projects in your local community. For example, the Pleasanton Unified School District helped passed a bond measure which is going to help divert funds towards new buildings and renovating school campuses. What makes municipal bonds attractive are that they may give you an exemption from federal, state, or local income taxes. They’re generally low risk compared to other types of bonds but municipalities can default on their bonds if they face significant and severe challenges.
These are issued by banks such as JP Morgan, Goldman Sachs, and Deutsche Bank. In the past, banks would get mortgages and package them up into a bond which they then sold as a mortgage-backed security. These became prominent during the 2008 financial crisis as greed and corruption almost caused the collapse of the international financial system.
Profiting Off Bonds
There are two main ways you can make money off bonds.
- Buy a bond and collect payments (interest + principal) on the maturity date.
- Trade the bond at a lower interest rate. You could buy at a higher interest rate and sell at a lower interest rate or buy at a lower market value and sell at higher market value.
Advantages of Bonds
- Bonds provide consistent returns and low risk which can be comforting to risk-averse people, such as the elderly.
- If a company goes bankrupt, the company’s assets get distributed to bondholders first before shareholders. This means you may be able to recoup some of your investment while shareholders might get nothing.
- The entity owes you money and interest! It’s not the other way around and you’re like a bank for them.
Disadvantages of Bonds
- While bonds are generally low risk, you also get low returns compared to stocks.
- If the entity is a company, there’s a chance they may go bankrupt and you don’t get your money back.
Usage of Bonds
In terms of the seller (government or corporation), bonds are used to raise capital. If a city wants to build a new park without having adequate money, they might issue bonds to pay for it, essentially taking a loan from the people. The U.S. Federal Government, and many other governments, use bonds differently. They buy and sell bonds to control the money supply, or the amount of money in the economy. This is not an important function of bonds to know as an investor, as it only pertains to the big picture, but it does explain the sometimes changing interest rate.
The changing interest rate can lead to you owning bonds that have a lower interest rate than the market’s interest rate. If you try to resell bonds to other investors when the current interest rate is higher than the interest rate you bought the bond at, you will need to offer your bond at a discount to attract buyers. In other words, when interest rates rise, your bond’s value will decrease as you would have to sell it for a discount to par.
Bonds are not full proof. If the bond seller defaults, or doesn’t pay the bond payments, it can refuse to pay them, making them worthless. Argentina has defaulted its bonds several times, and as a result, they are considered toxic to investors. In general, U.S. bonds are one of the safest investments because they are backed by the U.S. Government. The riskiest domestic bonds are corporate bonds, as corporations can go bankrupt. To allure buyers, corporations often offer higher interest rates. Credit agencies will rank the riskiness of bonds, using the letter system. Bonds rated AAA are extremely safe, while bonds given lower than B should rarely be bought.
While it may seem daunting to pick bonds, you can also invest in a bond mutual fund or ETF. Check out our recent article on that. Some examples are SCHP, which is a Schwab ETF that holds US Treasury Inflation-Protected Securities (TIPS), and VBMFX which is a Vanguard index fund that offers exposure to the entire US bond market.
In conclusion, bonds are one of many different assets that you can invest in. While bonds may have been an appealing investment a couple of decades ago, today’s relatively low-interest rates along with a booming stock market make bonds less appealing than they once were.