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You are here: Home / Finance Fridays / Investing Series / Investing Series: Understanding Bonds

Investing Series: Understanding Bonds

June 30, 2017 MilitaryDollar Leave a Comment

Bonds

Per reader request, I am starting a series on investing. As the blog continues, I will move on to more advanced concepts such as buying on margin, how to evaluate an investment, etc. For now, I want to start with the basic building blocks of market investing. Last week I covered stocks and today I am writing about bonds. These concepts will be referred to throughout the series.

What is a bond?

Last week in the stocks post we learned that stocks are a partial ownership in a company. You own a tiny piece of the company and if the company does well, you earn some money. If the company does poorly, you could lose money.

Bonds are different. A bond is ownership of debt. The company you own a bond for literally owes you a debt. Meaning, bonds are a loan that the company must pay back. Companies take out debt in order to fund expenses, often to build the company. A bond can also be issued by a government or other entities. It can be used to fund projects and activities, such as infrastructure work in the case of governments.

Unlike stocks, whose price is determined by the expectation of future earnings, a bond’s price is determined by the amount of debt and factors such as the likelihood of it being repaid. Also unlike stocks, a bond is issued for a defined amount of time. This is because the debt is taken out for a certain amount of time, at the end of which you expect to get your money back. Think of it like your mortgage or car loan – you know when that ends, right? Same thing here. The company or government that has issued the bonds agrees to pay interest on the bond for X numbers of years, at the end of which the debt will be paid.

Bonds are also known as fixed-income securities. Because the bond is a payment of debt, there is a known interest rate associated with it. So you can expect to receive a certain amount from that bond over time. It’s more stable and predictable than a stock, or so the theory goes. Generally, but not always, that is true.

Why do companies and governments sell bonds?

A company will sell bonds to raise money instead of borrowing money from a bank. Unlike with stocks, it is a way to raise money without giving up any ownership in the company.

The money raised from a bond issue can be used for any number of things. If it is a municipal bond, it may be used to build a city park or install new sewer equipment. For a company, they may use the money to invest in a new product line or expand operations.

How do I earn money with a bond?

When you purchase a bond, it will have an associated interest rate, also known as the coupon. That is the amount you will be paid throughout the life of the bond. The bond will also state the amount of the loan (the bond principal) and when the loan must be repaid (the maturity date).

A fixed-rate coupon bond is kind of your standard issue bond. It will pay the same percentage for the life of the bond. So, for instance, if you buy a $1000 face value bond with a 6% coupon, you will receive $60 each year as the bondholder. The time when you will be paid is known as the coupon date, and can be annual or semi-annual payments. Then, of course, when the bond matures you will also receive the face value of the bond. In this case, that would be $1000.

There are other varieties of bonds that pay differently. Zero-coupon bonds, as the name suggests, don’t pay out the recurring coupon amounts. Instead, you buy them for a discounted rate of the face value and wait for the maturity period, at which point you will (should!) be paid the face value. Convertible bonds allow you to convert your bonds into stocks if the share price rises. Callable bonds are those where the company can “call back” the bonds from the bondholders (you) if the interest rates drop enough. Different types of bonds come with different levels of risk and potential reward which can affect how much you earn in the long run.

What are the potential risks and benefits of owning bonds?

Of course, the benefit of bonds is the relatively conservative way to earn money. Unlike the nebulous stock market, bonds rely on the ability of the company to pay back their debt. So if you pick a good company, it can be a very stable source of income.

However, because bonds are a debt, there is always the risk that the bond issuer will default on the debt. That is, they won’t be able to pay it. Bond maturity dates can range from less than a day to more than thirty years. The longer the maturity period, the greater the chance the debt will not be paid because who knows what will happen 15 years from now?

Bond issuers will also have an associated credit rating, which will partially determine the price. Just like with your own credit rating, a bond issuer with a poor credit rating can expect to pay higher interest on the loan. That means you might earn more from the bond, but it also makes it a riskier investment.

Should I buy a bond?

Just like with stocks, you probably want to have some bonds in your portfolio. Bonds are generally considered more conservative than stocks, and they don’t necessarily move in the same direction as stocks. That is, if the stock market is falling bonds won’t necessarily also fall. So having some bonds in your portfolio allows for some diversification. However, the younger you are the smaller your bond portfolio is generally recommended to be. This is because younger people, who have a longer investing timeline, are able to withstand more risk. We have time to recover.

If you’ve read my Investing Secret post, you know I am not buying bonds right now. But I do still have bonds in my portfolio from previous years of investing. I’m a little bit under the “common wisdom” allocation of bonds for someone my age, but because I am working towards achieving financial independence and early retirement at a young age, I am willing to be more aggressive.

As I age, and as most people age, it becomes a better and better idea to invest more in bonds. This is because your investing timeline shrinks, so you want to consider having more conservative investments. Of course, in the end whether or not you own bonds will be a decision you make based on your own needs and risk tolerance.

As we continue in the Investing Series, I’ll talk more about different type of bonds and other securities.
Do you own any bonds? What do you like about them? What don’t you like?

 

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