If you read the previous post, “What Are Stocks?” and had a little bit of existing knowledge about investing, you probably expected that this post would follow it.
Why might you have expected that a post on bonds would follow right after a post on stocks? It’s because frequently in investing, the two main asset classes to invest in that one thinks of are stocks and bonds. In fact, you’ll often hear the two of them referred to together just like that: “stocks and bonds.”
Technically, bonds are part of a slightly larger asset class known as “fixed income,” but for our purposes here in an introductory overview of bonds, we’ll go ahead and consider them separately as their own asset class since there’s a lot that goes into understanding bonds.
Stocks are relatively straightforward, but bonds? Bonds can be, well . . . complicated.
There’s a deep rabbit hole that one can go down into with bonds, but we’re going to try to stay as close to the entrance as we can.
What Is a Bond?
So what is a bond? At its most basic level, a bond is a debt instrument that you might think of as similar to an IOU. With an IOU, a borrower acknowledges that he or she owes a lender a specific amount of money and agrees to pay it back (hopefully by a determined date!).
With a bond, the issuer borrows a specific amount of money, agrees to pay back the entirety of the principal on a specific date, and agrees to pay interest payments along the way at a predetermined interest rate and frequency (typically on a semiannual basis).
So when you purchase a bond, you’re basically loaning money to the issuer of the bond, the issuer will pay you interest payments until the end of the loan, and then at the end of the loan, the issuer will pay you back the original amount of money you loaned? In a nutshell, yes.
But as with many things in life, what seems simple enough can actually become quite complicated, and bonds definitely fit that description. We now need to define some terms that are used when discussing bonds and how they work.
- Par value: This is the face value of the bond itself–in other words, how much the bond will be worth on the date of maturity. For most bonds, this face value is $1,000. For example, a five-year, $1,000 bond costs you exactly $1,000 if you purchase it at its issue, and five years later, you receive exactly $1,000 back.
- Coupon: The coupon is the interest rate the bond issuer agrees to pay over the term of the bond. Remember how I indicated above that if you purchase a bond, you will receive interest payments along the way until the date of maturity? That’s what we’re talking about here.
Going back to our example, if the five-year, $1,000 bond you purchased had a coupon rate of 5%, then over that five years, you received $50 per year. If you held the bond all the way to the date of maturity, you received $250 total in coupon payments plus the return of your $1,000 in principal, thus receiving $1,250 total by the date of maturity. Your gain over that five years was $250, since the $1,000 returned to you on the date of maturity was your original $1,000. - Price: Now this is where things start to get tricky. The price of a bond is not what it cost the purchaser at its issue, but rather the price of the bond right now. Today. “What?” you may be thinking. “The price I paid at issue is the price today, right?”
No, it isn’t, and the reason it isn’t is that the overwhelming majority of bonds are not bought and then held all the way to maturity by the buyer. Instead, most bonds end up being sold at some point to other investors on the secondary market.
The price of a bond on the secondary market can get complicated, as it’s influenced by several different factors, each of which is beyond our purposes in this post. All you really need to understand here regarding bond prices in this general overview is that bonds are traded every weekday on the bond market, and that the price of any given bond can and does change. - Yield: A bond’s yield really only comes into play when the bond is being sold on the secondary market, because if the bond is purchased at its issue and held to the date of maturity, the yield is obviously the coupon of the bond.
The current yield of a bond, however, is different because the price of the bond, if it is being offered on the secondary market, has changed from the face value of the bond. The simplest way to calculate a bond’s current yield is to divide the annual coupon payment by the current price of the bond. That gives a rough estimate of the yield. (To get a truer picture of the yield requires more complex calculations, which are definitely outside the purview of this post.) - Duration: Bond duration is another complex calculation (and far beyond our purposes here), but it essentially boils down to this: Duration is a way to measure how much bond prices are likely to change if there is a shift in interest rates, either up or down. The longer the bond’s duration, the more sensitive its price is to changes in interest rates.
- Credit quality: The credit quality of a bond involves the likelihood or unlikelihood of the issuer defaulting on the coupon payments and/or return of principal. Perhaps you remember that in the previous post I talked about how publicly-traded companies issue shares of stock in order to raise capital for their operations. That’s one method of doing so.
Another method of raising capital is through debt, specifically through issuing bonds. Bonds issued by companies are known as “corporate bonds.” The credit quality of a corporate bond is going to be dependent on the current and prospective financial state of the company that issued it.
For example, if a company is not doing so well and its future is in question, yet it needs to raise cash and attempts to do so through issuing bonds, the credit quality of the bonds issued by the company will likely be considered to be on the lower side, given that the chance for default is higher than it would be if the company were doing well.
Who Issues Bonds?
So now that we’ve covered bond terminology, who exactly issues bonds? Essentially there are two main issuers: companies and governments.
I already discussed above in the explanation of credit quality why a company would issue bonds, so there’s not a lot more to say here other than to point out that corporate bonds are considered riskier investments than bonds issued by, say, the United States government. Why? You’ll understand momentarily.
The second main issuer of bonds is the government, and here we’re talking about multiple governments, actually. The United States government issues bonds. State governments issue bonds. Municipal governments issue bonds. International governments issue bonds. You get the idea.
Generally speaking, securities issued by the U.S. government–which are referred to as “Treasuries” because the U.S. Department of the Treasury is the issuer–are considered the safest investment there is. Why? It’s because the U.S. government will never default on its debt obligations, since it always has the ability to “print more money” to fulfill them.
Now, this definitely isn’t the place to dive into a discussion of the massive topic that is United States monetary policy and Modern Monetary Theory (MMT), so I’ll just make a quick comment to summarize Treasuries in relation to their relative safety.
If you invest in a Treasury security and hold it to maturity, you’re all but guaranteed to receive fully what the U.S. government agreed to pay you. I can assure you, if the U.S. government were to default on its securities, you’d have much bigger problems than losing money on your investments, because the only way that would ever happen would be for a nationwide–and probably worldwide–disaster the likes of which we have never seen to occur.
The catch with the safety of U.S. government securities? Higher safety means lower return. That’s the relationship between risk and return at play, which we haven’t talked about yet, but we will in a future post.
Finishing up U.S. Treasuries, the actual securities themselves are known by different names depending on their time to maturity. They are the following.
- T-bills: T-bills have the shortest range of maturities. The maximum maturity of a T-bill is one year.
- T-notes: T-notes have the middle range of maturities. Any maturity of longer than one year, up to the maximum of ten years, makes the Treasury security a T-note.
- T-bonds: T-bonds have the longest range of maturities. Any maturity longer than ten years for a Treasury security makes it a T-bond. You’ll typically see T-bonds issued with a thirty-year maturity.
There’s a final Treasury security that’s separate from these others: Treasury Inflation-Protected Securities (TIPS). TIPS are debt securities just like the ones above, but they are different from them in that the return from TIPS is adjusted for inflation based on changes in the Consumer Price Index (CPI). TIPS are issued in maturities of five, ten, and thirty years. We haven’t really covered inflation yet, but we will in a future post.
Still with me? I realize that’s a lot, so let’s wrap up with some final words about bonds as an asset class.
Good News: Bonds Are Simpler Than You Might Think
You may have reached this point thinking, “Man, bonds are really complicated. This is a lot to keep up with.” I get it, and as I said earlier, bonds can be complicated.
But I have good news for you: For the everyday investor (you), they become a lot less complicated through the use of bond mutual funds and bond ETFs. Granted, we haven’t covered mutual funds or ETFs yet, but like with many other things, we will.
Put simply: If you are an investor who wants to invest in bonds, you can do so rather easily by investing in a fund that invests in multiple bonds for you rather than you investing in one or more bonds yourself by purchasing them individually from the issuers or individually on the secondary market.
And why would you want to invest in bonds at all? Well, similarly to what I did in the previous post, I’ll summarize it like this:
We invest in bonds as an asset class because they have historically been the most reliable way to generate a relatively small amount of return in an investment portfolio over the long term while simultaneously providing stability to the portfolio during volatility in the stock market.
The relationship between stocks and bonds as asset classes is a lengthier discussion than what we can get into now. But we’re heading there soon.
Questions or comments on bonds? Feel free to leave them in the comments section, and I’ll try to respond.