Bonds 101: Understanding How Bonds Work
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The bond market is a massive part of the global financial system. In fact, it’s almost twice as large as the stock market.
Political strategist James Carville once said, “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
The bond market may be intimidating, but it doesn’t have to be. Understanding a few key concepts and a little bit of terminology will help you navigate the ins and outs of bond investing.
Bonds are simply a way for governments and companies to borrow money. Instead of borrowing money from a bank, a company or government can sell bonds to a large group of investors to raise the funds it needs to operate or grow. Issuing a bond is usually less expensive than a bank loan and tends tooffer more flexibility.
For investors, it’s helpful to just think of yourself as a lender when you invest in bonds. Investors buy bonds from the company/government that issues them, and the company/government promises to pay back investors the principal amount plus interest. Interest payments are paid regularly (usually quarterly, semi-annually or annually) until the bond “matures” or reaches the end of its agreed term.
Bonds are issued in varying term lengths, and may mature in the very short term (days or months), short term (one to five years), medium term (six to 10 years) or long term (more than 12 years). Typically, the longer the term of the bond, the higher the coupon rate on the bond will be. The coupon rate simply tells the investor the amount of interest he or she will get over the life of the bond. For example, a bond with a 5% coupon rate and a $1,000 face value will pay the bondholder $50 each year.
Bonds also have a credit rating based on how likely they are to be paid back in full. These ratings vary by the ratings agency that is assigning them, but they generally range from AAA for the highest quality bonds down to D for bonds in default or non-payment.
The lower the credit rating, the higher the risk of default. For the investor, that means higher potential returns for taking on more risk.
How the Primary Bond Market Works
Bonds issued in primary markets are similar to a company’s initial public offering (IPO) of stock. Companies looking to raise money via bonds coordinate with investment banks to set the coupon rate, the terms of the issue (called the indenture agreement) and the total amount of money the company is going to raise.
The investment banks then sell the bonds to large institutional investors (who make up the bulk of bond buyers) through an initial offering. These bonds are issued by the borrowing company at anoffering price that is uniform for all investors. This standard price is known as the par value, which is usually $1,000 per bond. However, just to make things more complicated, it is common for a company to issue bonds at a discount (for example, selling a $1,000 bond for $995) or a premium (for example, selling a $1,000 for $1,010).
The vast majority of individual investors will never take part in a company’s initial bond offering. It’s much more cost effective for companies to go straight to the big institutional investors.
But government bonds, like U.S. Treasury bonds, are relatively easy for individuals to buy in the primary market. Government bonds, including municipal bonds, generally have lower yields, but also have less risk and more tax advantages than corporate bonds. Government bonds are also much less complex investments, perfect for a beginning bond investor. There’s no need for a broker — you can purchase bonds directly from the U.S. Treasury at TreasuryDirect.
After the initial offering, investors may buy or sell bonds on the secondary market through brokers. Think of a secondary market like a used-car market, where once “new” bonds are sold secondhand to other investors.
Secondary markets are much more accessible to smaller investors, and you don’t have to be aninvestment banker to take part. However, it’s vital that investors understand how bond prices move when interest rates change. As a rule, when interest rates rise, bond prices fall. The opposite is true as well — as interest rates decline, bond prices increase.
However, the change in interest rates impacts bonds differently depending on many factors, including time to maturity. Individual bond investing is complex and requires much more diligence and research than stock investing.
As with all investments, it is important to assess risk when purchasing bonds. Look at price, interest rate, yield, redemption features, taxation and the company’s credit history and rating when weighing which bond to choose.
Investing in individual bonds can be expensive, especially if you want to buy several different bonds to create a diversified portfolio. Most brokers make you spend at least $5,000 per transaction (though the bond market is bigger, trading is much, much less frequent, and is therefore done in much larger increments). If you don’t have that much capital to invest, an affordable investment alternative is a bond fund.
Want to increase your exposure to bonds without having to be a bond expert? Try a bond fund. Bond funds can be purchased through a broker just like stock funds.
Bond funds offer several advantages over individual bonds, including professional management, oversight and diversification. A bond fund may hold a variety of bonds with different term lengths, credit ratings (AAA to D) and types (government and corporate bonds). Because all of these different bond prices may fluctuate at different rates, having the diversity of a bond fund can help reduce risk.
As an added benefit, bond funds typically have a lower minimum investment to purchase ($250 to $1,000) than individual bonds. The disadvantage, however, is that bond funds charge an expense fee just like any other mutual fund – typically taking between 0.5% and 1.5% off the top of your annual return. So if your bond fund returns 6%, the actual return you may receive may be 4% to 5.5% after expenses.
Bond Exchange-Traded Funds
For those interested in a bond investment with lower expenses, a bond ETF makes a great alternative investment. Just like a bond fund, these securities may hold several bonds, diversified by term, credit risk, and/or type. A key difference is they are not actively managed — which results in much lower fees.
Bond ETFs are much like stocks in that they are traded on the stock exchange. Like stocks, bond ETF prices fluctuate with demand. Also like stocks, bond ETFs can be sold at any time.
The Investing Answer:
For most individual investors, the best way to invest in bonds is throughTreasuryDirect, bond ETFs and bond funds. In most cases, bond prices move in the opposite direction of stock prices — bonds tend to zig when stocks zag. Over the long term, the idea is to have your bond investment gains offset your stock investment losses and vice versa — so you can have a more diversified portfolio with less overall risk.
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