How do bonds work?
Bonds are basically a much more formal promissory note used to borrow money. You buy the bond for interest over a set period of time. When a company or government needs money, they issue bonds which people buy. In turn, the issuer (the person selling the bond) takes the money. But no one would buy anything if they didn’t get something in return, so the issuer will offer to not only pay the person back at a set date but also give some interest along the way. There are two main types of bonds:
Government bonds
These bonds are issued by governments that want to borrow money. It can be issued by any level of government; large cities often issue bonds to fund public projects, while national governments issue bonds to fund the state. When you hear about a country’s sovereign debt, it usually means the amount of bonds it currently has issued. Treasury bonds can be traded by normal investors, but they can also be bought and sold between countries (if you hear an expert mention that the US government owes money to another country, like China, it’s almost always because that country bought a very large number of Treasury bonds), or even between different parts of the state. In the US, the Federal Reserve buys and sells bonds from US Treasuries to influence prevailing interest rates, for example.
Corporate bonds
Companies can also sell bonds, which is essentially borrowing money from a large pool of investors. Smaller companies can usually only take loans from one bank, but if the company is very large (like Apple (AAPL), they use more cash than banks can usually give out in a single loan. Instead, they will issue bonds to investors, with a promise to pay back at a certain date with interest. Bonds are one of two ways that companies often use to raise extra money that they use for investment and expansion; the other is by issuing shares. However, there are very important differences between the two: – If you buy a bond, you are lending money to a company and they promise to pay you back later with interest – If you buy a share, you are buying a share of the company and are entitled to a share of its profits (in the form of dividends). – The value of the bond comes from how much you lent the company and what interest they will pay back to you – The value of a share comes from how much the company itself is worth (including all its assets and operations) – Bonds mature; at the expiry date you get back the amount you lent – Shares do not (normally) mature.
Details
Bonds can be bought and sold just like stocks, or they can be bought once and held to maturity at which point they will mature and return the face value. When you buy a bond and hold it to maturity, you will receive a certain predetermined interest rate (or coupon). Remember that even though a bond represents a sum of money that you lent to a government or company, they can still be bought or sold between investors like stocks. This means that you can buy a bond from Google (GOOG), but then sell it to another investor who will then continue to receive the interest and receive the amount you initially lent to Google when you bought the bond. Similarly, you can buy bonds from other investors instead of buying them directly from the company that issued them. Investors will typically buy bonds when they are very risk averse, meaning they would rather have the guaranteed payment of regular interest than make riskier investments like stocks, whose value can rise and fall a lot over time. Here are some terms that are important when looking at bonds:
Nominal value
The face value, also known as par value or principal is the amount of money you will receive when the bond matures. This is almost always $1000 but there can be exceptions.
Coupon
This is the interest you get on your bond each year. It’s usually stated in terms of the coupon rate (as a percentage). You then multiply your coupon rate by your face value, which in most cases will be $1000, to get your coupon. For example, if a bond is quoted at 4.00%, you will receive $40 each year. Bonds can also be paid several times a year and are usually semi-annual (twice a year). In this case, your coupon rate remains the same at 4.00% but you would receive two coupons of $20 instead of one coupon of $40.
Decay
The maturity date is when the bond expires. If you hold the bond at maturity, the bond issuer will pay you the face value of the bond, which is almost always different from what you originally paid for it. In addition to the face value of the bond, if your bond had a coupon you will also receive a final payment of the interest that has accrued since the last payment was made. After this point, the bond issuer’s debt to the bondholder is considered settled.
Return on investment
Since bonds are bought and sold between investors just like stocks, the value that they are bought and sold for in the market may not be exactly the same as the interest payments left until the bond matures and the face value. This is a very difficult concept to understand for many investors but is essentially the return you get when you take into account the price you paid for your bond. The price of the bond is affected by the risk-free rate and the bond’s own interest rate, as well as many other factors. The higher the yield, the better the bond looks compared to other investments.
Accumulated interest
The interest payments on bonds are not paid daily; they are usually paid out once or twice a year (depending on the bond). However, the bond issuer owes the holder of the bond interest for as long as they held it; if you only own a bond for one day, you are still entitled to one day’s interest. This is important for investors who buy and sell bonds a lot; if you own a bond that pays interest once a year on July 1st, but you sell it to someone else on June 15th, you are entitled to the majority of the interest payment that they receive from the bond issuer on July 1st. For example, let’s say John bought a 5% 10-year semi-annual bond on the day it was issued and waits a year and 2 months before selling it to Karin. This means that John received two $25 coupons in the first year and is entitled to an additional $8.33 from the bond issuer on top of the price he sold the bond for. This is because he held it for an additional 2 months, hence 2/6 * $25 = $8.33.
Accrued interest with pricing
When looking at accrued interest, it has a huge impact on the prices of bonds. Investors look at this in terms of a dirty price of bonds and a clean price. The dirty price is the price that the bond trades for in the markets (if you bought a bond from another investor, for example). This price does not subtract the accrued interest from the value of the bond. The clean price is the price with the accrued interest subtracted. Dirty Price = Clean Price + Accrued Interest When you get a quote on a bond, you will almost always get the clean price, but when you buy it, you will always pay the dirty price.
Grading
A rating is given to bonds to determine their level of risk. They are usually carried out by third-party rating agencies such as Standard and Poors, Moody’s or Fitch. Rating systems differ from company to company but it is important to know the difference between different bond ratings. The most common bond ratings are as follows: – AAA: Strongest Quality Rating, this has a very very low risk of default. – AA+ to AA-: Very high quality investment grade – A+ to BBB-: Medium quality investment grade – BB+ to BB-: Low quality (non-investment grade) “junk bonds”, high risk of default – CCC+ to C: Speculative grade bonds with very high risk of default. – D: Bonds in default and likely to be unable to pay principal and/or interest.
Portfolio
Almost every balanced portfolio should have a place for bonds, if only for their strong safety while beating inflation. Bonds can also be very risky, such as junk bonds (bonds issued by governments or companies that are highly unlikely to be able to pay back), which can pay high coupon rates but have a high risk of default. There are also many different types of bonds as well, such as convertible bonds that can be converted into shares or inflation-protected bonds that simply track the rate of inflation.
Bond ETFs
You can also gain exposure to bonds through bondETFs. They have some notable differences between bonds in terms of tax considerations and yield but are much easier to trade.
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