“Slow and steady wins the race” — well, unless stacking up on mortgage-backed securities in 2008 was the investment plan, then perhaps scrap that quote. Nonetheless, bonds are considered safer bets against other assets and this article will explain all about bond investing basics. The topics discussed: what bonds are, why it’s issued, its uses, and its risks.
What are bonds?
Bonds are an obligation of a borrower to a lender to pay back the full borrowed sum after a specified duration plus payments on interest during the course of the bond’s effectivity.
For example, if an investor purchased a corporate bond, he essentially lent cash to a company making him the lender and the company the borrower. The company should pay him a percentage of the amount they borrowed on an ongoing basis and the principal at the end of the bond’s life.
Let’s say that Jack purchased a bond from company X at its face value of $1000 with a maturity of 10 years and a coupon rate of 6%. This means that company X is obliged to pay Jack, the holder of the bond, $60 every year until it matures (or expires) after a decade plus the principal amount of $1000.
What this equates to at the 10th year is that Jack will have collected $600 or 60% of his initial investment of $1000 — without factoring in inflation.
Why are bonds issued?
Bonds are issued so that companies or even the government can fund certain projects, acquire new assets, expand, and other purposes (in our how stock investing works, we discussed one financing strategy a company utilizes: equities).
Companies that offer bonds may find that it has some advantages over stocks in that bonds do not dilute the ownership of a business and it does not affect valuation. Because when companies offer stocks they give up a portion of their business to the public, and as those shares change hands daily, their value also fluctuates.
A bank loan is another option for companies, but they do have limits or restrictions which is virtually absent in a bond for as long as investors think a company is good for it, then the company can continually issue bonds. And, bonds also offer more flexibility for a company and a way for them to variegate their financing.
Uses of bonds
Bonds vary in purpose. To an investor, a bond is an instrument to earn constant and predictable income through coupon payments by the issuer.
Bonds are also a diversifier for an investment portfolio. As stocks are considered riskier because of the unpredictability of how the market treats its price, bonds serve as a cushion providing an upside to a portfolio when things go awry with stock holdings.
The reason for that is when interest rates rise (specifically the fed funds rate), it is seen as a tightening of credit supply, and this has far-reaching effects. One specific area the Fed’s interest rate decision affects is spending. If money is cheap or credit is accessible, it means they have more to spend which, in Ray Dalio’s words, is “another person’s income.”
Most companies rely on consumers to purchase their products or services in order for them to make a profit, but if the Fed is hell-bent on raising rates, they may see a tapering of such voracious spending. And, lesser spending would obviously affect a company’s bottom line.
Also, in a rising rates scenario, investors tend to move their money from stocks to new government bond issues due to what is called alternative cost — the preference for riskier investments like stocks only makes sense if the returns on safer investments are inferior.
Much like stocks, bonds are also traded on stock exchanges, but more commonly, over-the-counter. And, since bonds can be traded and are affected by interest rate changes too, price fluctuations also occur which prompts traders to capitalize on these differences for profits.
Lastly, the traditional use of bonds is to allocate income for certain expenses and/or liabilities. Considering the expected coupon payments, a bond investor can apportion for certain expenditures in a defined time horizon.
Risks of bonds
The interest rate is one of the risks that a bondholder faces because it affects the price of a bond: when interest rates go up, bond prices go down or vice versa. To help investors understand this inverse relationship, the Securities and Exchange Commission (SEC) uses a seesaw analogy.
The simple explanation for this is, again, the alternative cost. A bond with a 6% coupon rate and a $1000 face value wouldn’t be as attractive as a newly issued government bond with a 7% coupon rate with the same face value; therefore, the 6% bond would be valued less than $1000 in the market.
Whenever the equation involves a lender and a borrower, there is a risk of default and, bonds, which is essentially a form of credit, aren’t excluded. Even big companies may fail to honor their commitment to their creditors and that’s undesirable for bond investors. And, even if the U.S. government can print money to service its debt, there is still some risk associated with it. That is why there are credit rating agencies like Moody’s and Fitch that assess the bonds offered by governments and corporations.
Lastly, rising prices are also a concern for bond investors because it means that the coupon payments they receive are not going to have the same purchasing power as it had, say, a year ago. The real return of a bond will also be different because of the inflation rate. For example, the coupon rate of 6% will be reduced to 4% if the inflation rate is currently at 2%.
Furthermore, when inflation goes up, the Fed counteracts by raising the fed funds rate to prevent the U.S. economy from overheating and, as mentioned, interest rates affect bonds too.
Bond investing warrants plenty of research time for the investor. The rating of a bond should be assessed, the inflation rate must be considered, the proper pricing of a bond, risks, the market’s cycle, and other factors. Through diligent research prior to locking funds on a bond is necessary for preventing any miscalculation.