Bonds — also known as fixed income — are one of the main tools investors and advisors use to add stability to an investment portfolio.
Nevertheless, how bonds work and how they provide stability remains a mystery to many. So let’s recap some of the basics, including what bonds are and how to invest in them. Think of it as Bonds 101.
What is a bond?
A bond is essentially a loan. You lend the issuer an amount of money for a certain period of time in return for a “bond” that is repaid to 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, as determined by the fixed interest rate, bonds are commonly referred to as fixed-income investments. Sometimes, bonds are simply referred to as debt.
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.
A bond’s interest rate depends on a variety of factors. It can help to think about it like a mortgage. When a bank lends money to someone with a low credit score, they generally charge them more in interest to compensate for the risk that the borrower may not repay the loan.
Bonds work in a similar way. If an issuer is considered risky, they tend to offer a higher interest payment on their bonds to account for that risk. On the other hand, if an issuer is considered creditworthy, they may pay less interest, since the investment is viewed as less risky.
Ratings agencies help investors assess how creditworthy a bond issuer is. They also place ratings on the bonds themselves. 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. 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 you also generally risk losing your principal investment as well.
In general, bonds issued by the U.S. government are considered to be the safest, since the federal government has never defaulted on its debt. U.S. government bonds are known as treasuries.
Currently, it is very rare to buy bonds directly from the issuer. Many bonds are bought and sold on a secondary market, where prices can fluctuate. As a result, the price of a bond isn’t always equal to its face value. 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.
Investing in individual bonds is complex and can be risky, so I prefer to invest in bonds via bond funds. Bond funds tend to own and track various fixed-income investments. Some funds accept direct investments, while others are traded on exchanges (exchange-traded funds or ETFs).
Bond funds offer a number of advantages. Examples include not investing $1,000, withdrawing your money prior to the maturity date, and gaining exposure to a wide range of fixed-income products via a single investment.
However, bond funds generally come with management fees. I recommend always checking a fund’s prospectus, or having an advisor who does this for you, to determine the fee ratio. It’s also a good idea to look at the type of bonds the fund invests in (U.S. treasuries, corporate debt, municipal debt, etc.) to make sure the fund aligns with your risk tolerance.
An advisor reviews and selects funds based on your goals. For me, this means looking at two things: duration and yield. Long-term bonds tend to pay higher rates than short-term bonds (much like a 30-year mortgage carries a higher interest rate than a 15-year mortgage). And yields can vary based on a variety of factors, duration included.
If you have long-term investment goals and you’re focused on growing your money, the bond duration and yields discussed would be different than those discussed with someone who is retired and focused on capital preservation and income.
Have more questions about how bonds might fit into your portfolio? Reach out and we can discuss.