Looking for a simple explanation of bonds?
The investing world has a way of making things tricky for us. There’s a lot of acronyms, terms, and jargon (words used by professionals that are hard for others to understand).
Bonds, however, are one of the easiest financial terms you will understand.
Read the following slowly, take your time. Ask yourself, does this make sense?
I’m confident that you will have a better understanding of bonds and how they work after reading this.
What is a bond?
Don’t you just love when you read a definition but still have no idea what the word means?
Okay, Merriam-Webster…thanks, but no thanks.
You’re probably still asking, “What is a bond in SIMPLE TERMS?”
A bond is simply a loan.
It’s a legal contract between two “people”. A lender and a borrower.
The lender is the person (investor) lending the money and the borrower is the one borrowing the money.
The borrower issues the bond. Bonds are issued by companies and governments. Most bonds are issued by governments.
So, when you buy a bond, it’s a legal contract between you (the investor) and a company or government.
Now, let see how bonds work.
How do bonds work?
When you invest in bonds (buy bonds), you are loaning money to either a company or a government.
In return, you get paid interest and the money you initially lent.
The interest is paid on a set payment schedule. Most payments are either semi-annually or annually.
How long do you get interest payments? Until the bond matures (when the loan ends). When the bond matures, you also get back the money you initially lent.
Not all bonds have payment schedules but most do.
Let’s review the main components of a bond. There are five main components.
The coupon rate is the interest rate. The interest rate is used to calculate your interest payment.
The coupon payment is the interest payment. Most interest payments are paid semi-annually (twice a year) or annually (once a year).
The yield is the return on investment. The higher the yield, the higher the return.
The maturity date is the length of the loan. This will help you understand how long you have to wait until you get back the money you lent. In the meantime, you will receive interest payments.
The face value is the price the investor pays for the bond from the issuer. It’s also how much you’ll get paid back when the bond matures.
If an investor wants to sell his/her bond before it matures. It’s most likely not sold at face value. The price of the bond is now determined by market value.
It’s important to understand the creditworthiness of a bond.
Creditworthiness is how likely the borrower is to pay you back.
You eventually want your money back right?
Then it’s important to review a borrower’s creditworthiness. Remember that the borrower is the one who issues the bond, the one who needs to borrow money.
Lucky for us, we don’t have to look into a company or government’s financials to understand their creditworthiness.
Credit rating agencies do this work for us. The most well know agencies are Standard & Poor’s and Moody’s.
The best credit rating a bond can get is AAA. This means that the borrower is very likely to make the regular interest payments and when the bond matures, pay you back what you lent them.
The lowest credit rating is a D. I would suggest staying far away from bonds with a D credit rating.
Types of bonds
There are many different types of bonds. Bonds have different interest rates, maturity dates, coupon payments, etc.
But when it comes to who issues them. By now, you understand that there are only two. Companies and governments.
One of the most popular bond questions is, “What are government bonds?”
A government bond is a loan issued by the government.
When governments need to borrow money, they issue bonds.
When you decided to buy a government bond, you are letting the government borrow money. In return, you get paid interest until the bond matures. When the bond matures, you get back the money you initially let them borrow.
Government bonds are issued at the federal, state, and municipal (local) level.
Government bonds issued at the federal level are US Treasuries.
US Treasuries include; Treasury Bills, Treasury Notes, Treasury Bonds, and Treasury Inflation-Protected Securities.
The above US Treasuries all have different characteristics. As an investor, that’s great because that means you have options. For example, if you want your money back in as little as one-year. You can invest in Treasury Bills that have a one year maturity date.
Overall, US government bonds have really good credit ratings. They have good credit ratings because the likelihood that the US government is going to pay you back is high. The government can just print money if it needs to pay back it’s debt (bonds).
Given that you will most likely get your money back, government bonds are a low risk investment. If the risk is low, the yield (return on investment) is also low.
Low Risk = Low Yield
Learn more about US government bonds.
A corporate bond is a loan issued by a company.
When a company needs to borrow money, they issue bonds.
When you invest in corporate bonds, you are letting a company borrow money.
You understand how bonds work now so I don’t have to go into details but there are a few things to mention regarding corporate bonds.
Corporate bonds typically don’t have high credit ratings like US government bonds do so it’s important to review the company’s creditworthiness.
It’s important to understand a company’s creditworthiness because you’ll want to know how likely it is that you will get your money back plus receive the scheduled interest payments.
In short, remember to always review a corporate bond credit rating.
Also, because corporate bonds don’t have the highest credit ratings (not all companies) as US government bonds do.
Corporate bonds are riskier thus have higher yields (return on investment).
High Risk = High Yield
If you’re interested in investing in corporate bonds, meet with a Registered Investment Advisor (RIA). An RIA is a professional that will help you make the wisest decisions given your unique situation.
How to buy bonds
You can buy bonds through a brokerage account or directly from the issuer (company or government).
You can also buy bonds from the secondary market. Buying bonds from the secondary market means you are not buying them from the issuer. You are buying them from someone who already owns the bond.
When you buy bonds from the secondary market, the price becomes the market value, not the bond’s face value.
The market value of a bond is determined by multiple factors. Factors include; current interest rates, maturity dates, and similar bonds being sold.
Let’s say you have a bond with a face value of $1,000 and an interest rate of $2.5%. The coupon payment would be $25 a year.
You’re looking to sell your bond in the secondary market. The current interest rate is 2%. On a $1,000 bond, that’s a $20 coupon payment. Your bond is worth more because your bond’s interest rate and coupon payment are higher. Given this situation, you can probably sell it for more than $1,000.
The opposite would happen if you were trying to sell your bond when interest rates are higher than your bond.
For example, the interest rate is 3%. On a $1,000 bond, that’s a $30 coupon payment. If someone wants to buy a bond at the current interest rate of 3%, your 2.5% bond wouldn’t be very attractive. You would have to then sell it at a discount. So less than $1,000.
Lastly, you can invest in bonds as part of a mutual fund or ETFs (Exchange Traded Funds). You can learn more about mutual funds in Index Funds For Beginners.
Investing in mutual funds and ETFs is a way of diversifying your bond portfolio. Instead of investing in just one bond, you can invest in the entire bond market or just part of the bond market.
If interested, meet with a Registered Investment Advisor to learn more!
Benefits of bonds
Compared to other types of investments, generally speaking, bonds are a safe investment. Especially US government bonds.
The risk is low and you will likely get your money back.
You receive regular interest payments. The issuer pays you on a set payment schedule so you’re guaranteed a steady income.
You have options. You can choose from different types of government and company bonds. If you want to take a risk and get a higher yield, you have that option as well.
Disadvantages of bonds
Because bonds are safe, the return is low. Compared to other investments like stocks, the return on investment is lower.
There’s a possibility you won’t get your money back. If you bought a risky bond with a low credit rating, it’s possible the company or government won’t back you back.
You never know exactly what’s going to happen but to avoid this as best you can, do your search.
Invest in bonds with high credit ratings.
Secondary market value risk.
If you need to sell your bond before it matures and the interest rate is higher than your bond, you will most likely have to sell below face value. Aka, less than what you bought it for.
To avoid this as best you can, make sure the maturity date is realistic. Can you wait 2, 5, or 10 years to get your money back?
what is a bond summary
We’ve come a long way. I’m confident that after reading this post, you’ll have a much better understanding of what bonds are and how they work.
- A bond is simply a loan. A legal contract between two “people”. A lender and a borrower.
- Bonds are issued (sold) by borrowers.
- There are two types of borrowers, companies, and governments.
- Bonds have a set payment schedule that pays the investor (lender) interest.
- Understand a bonds terms. The coupon rate, coupon payment, yield, maturity date, and face value.
- Always review a bond’s credit rating. How likely is it that you will get your money back?
- Overall, bonds are a safe investment. A safe investment with a low return on investment (yield).
- Meet with a Registered Investment Advisor (RIA) to add bonds to your investment portfolio.
I hope this has helped you better understand bonds. Continue to look into your investment options and don’t forget to ask the professionals about the right bonds for YOU.