Bonds — also known as fixed income — are an investing mainstay. “They’re almost required in every portfolio,” says Wealthbridge founder Tim Randle. “In the right dosage, of course.”
But how bonds work, and the different ways to invest in them, remains a mystery to many. So let’s recap some of the basics.
What is a bond?
A bond is essentially a loan. You lend the issuer an amount of money for a certain period of time and they give you a “bond” that they will repay you, with a fixed rate of interest. At the end of the term, you receive the principal amount back (unless the issuer defaults). Because you’re paid income, via a fixed interest (or coupon) payment amount, these are commonly referred to as fixed-income investments. Sometimes, bonds are also referred to as “debt.”
Bond illustration
In the bond above, the face value, or the amount of the loan, is $1,000. This is a standard face value for most American bonds. The term of the bond is 10-years — when the term is over, the bond has reached maturity.
The annual interest rate of the bond, or its coupon rate, is 4 percent. Most issuers make coupon payments semi-annually — meaning the bondholder would receive $20 every six months. (Annual rate of 4 percent = $40, in two payments of $20.) Because the bond yields interest payments, these payments are often referred to as the bond’s yield.
What rate a bond pays depends on a variety of factors, and it can help to think about it like a traditional loan. If you’re lending money to a borrower you consider to be very “safe,” you’re not likely to charge them a high rate of interest; you probably charge close to market rate. However, if the borrower is less creditworthy, you might charge them more in interest to compensate for the higher risk that you might not get your principal back at maturity. Similarly, bonds issued by less creditworthy entities pay higher yields to compensate investors for the risk.
To help investors assess how creditworthy a bond issuer is, ratings agencies place ratings on debt. There are three main agencies — Fitch, Moody’s and S&P — and they each use their own lettered systems. The top ratings-tiers are known as “investment grade” but if a bond falls below a certain rating, it can be labeled “high-yield” or sometimes “junk.” In these cases, it can be helpful for investors to do additional research into the issuer to assess the risk. If a bond issuer defaults, you not only miss out on fixed-income payments, but generally risk losing your principal investment as well.
In general, debt issued by the U.S. government is considered to be the safest, since the federal government has never defaulted on its debt.
Buying bonds
It’s very rare nowadays to buy bonds directly from the issuer. That means many bonds are bought and sold on the secondary market. This means the price of a bond can fluctuate based on a variety of factors. Consider this example:
Bond A has a face value of $1,000 and a coupon rate of 2%. Several months later, Bond B is issued for $1,000. Let’s assume market interest rates have increased, so Bond B has a coupon rate of 4%.
It’s unlikely anyone would purchase Bond A if Bond B were available, since bond B offers a higher return. In order to make Bond A more attractive, the market price would likely fall — let’s say to $900. When you hear financial professionals talking about bond prices, versus bond yields, this is the relationship they’re referring to.
If you had bought Bond A for $1,000 and this happened, your investment account may show a paper loss. That’s because if you wanted to sell Bond A, you’d only be able to get $900. However, if you hold the bond until maturity, you’ll still receive the $1,000 face value. It’s important that investors distinguish between paper losses and intrinsic value.
“Buying bonds isn’t as transparent as buying a stock, and the process isn’t as simple,” says Randle. The investments can be very expensive, and don’t always offer broad exposure. “We work a lot with bond funds, instead. They offer more benefits to our investors.”
Bond funds
Bond funds tend to own and track various fixed-income investments. Some funds might focus on emerging market bonds, others on corporate debt or even a mix of U.S. treasuries. Some funds accept direct investments, while others are traded on exchanges (exchange-traded funds or ETFs).
Bond funds offer a number of upsides: You don’t need to invest $1,000, you don’t have a set timeframe and can withdraw your money without waiting for a maturity date, and you may be able gain exposure to a diversity of fixed-income products via a single investment.
However, bond funds generally come with management fees. Advisors evaluate who the best managers are and evaluate fees and returns, then select funds accordingly.
If you’re investing your own money, check a fund’s prospectus to see what the fee ratio is. It’s also a good idea to look at the type of bonds the fund invests in (U.S. treasuries, corporate debt, municipal debt, a combination of all the above, etc.) to make sure the fund aligns with your risk tolerance.
“Sometimes clients have the perception that bonds are just for retirees or extremely cautious investors,” says Randle. “But bonds, especially U.S. treasuries, can act as a shock absorber for aggressive portfolios. When things are going badly, a bond investment — even a relatively small one — can offer a good amount of protection.”
Diversification and asset allocation strategies do not assure profit or protect against loss. Past performance is no guarantee of future results. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including loss of principal.