Today we discuss one of my favorite topics – debt! You know how much we believe in leveraging debt, right? Clothes, gadgets, new cars, it’s all affordable with debt!
Just kidding. You’re a nut if you finance any of the previously mentioned items with debt. Sell them and try again when you can afford to pay with cash.
If you insist on holding debt, hold someone elses! Welcome to the world of bonds!
Bonds are debt investments in which you loan an organization money with the agreement that they must pay you back the original amount in full, along with an agreed amount of interest – Just like a formal IOU. Bonds are also known as fixed income and fixed interest investments, and that’s because they pay out a fixed amount at a fixed date. You’ll here some common terms surrounding bonds. So here is a reference if you get lost.
- The issuer is the entity (company or government) who borrows the money by issuing the bond.
- The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer borrows which must be repaid to the lender.
- The coupon (of a bond) is the annual interest that the issuer must pay, expressed as a percentage of the principal.
- The maturity date is the end of the bond, the date that the issuer must return the principal.
- The indenture is the contract that states all of the terms of the bond.
Bonds are issued by companies and governments to raise money. While issuing bonds, the issuing business doesn’t have to relinquish ownership to raise new capital (as is the case when issuing stock), but they do have to repay this borrowed money with interest. When a bond is issued, it includes a specified maturity date at which time the principal will be repaid. These maturity dates are often broken up into short, intermediate, and long term bonds. You will see some discrepancy on the exact time frame of each classification, but the numbers are close. So generally:
- Short-term bonds mature in 1-3 years.
- Medium or intermediate-term bonds mature in 4-10 years
- Long-term bonds are those with maturities greater than 10 years.
Bonds are issued at a particular interest rate (what’s known as a coupon). This rate is fixed on most bonds, but not all.
For example, a $1000 par value bond issued with a 5% annual coupon rate will pay the investor $50 per year in interest.
As the maturity date of a bond increases, so does the coupon rate. This higher yield can be attributed to many factors which increase investor risk, such as increased chance of bankruptcy for the issuing company, increased chance of interest rate fluctuations, questionable inflation levels, and even the behavioral aspect of an increased commitment for a longer period of time.
So bond interest rates rise as the maturity date gets pushed further out. This is a result of increased risk and the old investing mantra holds true: greater risk = greater reward.
Understanding Bond Yield and Pricing
As a reminder going forward, remember that the face value and coupon of a bond never change. Never.
So if you buy a bond new and hold it until maturity, you’ll get exactly what was promised – A series of fixed payments plus the return of your original investment (the face value).
But what happens if you buy someone elses bond or if they buy yours? Well it gets more complicated and it depends on the current market value of the individual bond.
You might be wondering why the current market value of a bond is different that the original face value. Most commonly, it’s due to changes in interest rates. Since some bonds are very long term investments, it is common to see changing interest rates throughout the period when the bond is outstanding.
If a bond is issued, then interest rates rise, the bond will be worth less. This is because new bonds are being issued with higher coupon yields, resulting in higher payouts for investors. Why would anyone buy your old bond paying 4% if new bonds are paying 6%?
The reverse is also true. If rates drop, your bond is worth more. People are far more interest in a 4% coupon when new bonds are being issued at 3%.
When these interest rate fluctuations take place, an individual bond will be priced accordingly. The face value and coupon do not change, but the market value does.
For example - You bought a $1,000 face value bond with a 4% annual coupon rate. Rates rise and bonds are issued at 6%. If you keep your bond, you’ll make $40/year until maturity. If you try to sell, no investor is going to pay your $1000. They are going to pay you less to reflect your lower coupon. In this case, they might pay $667. That price would mean that your original bond now pays roughly 6% just like the other bonds on the market ($40/$667 = roughly 6% yield)
As you may have guessed, the longer the maturity date, the more dramatic the effect of interest rates. Long term bonds are far more sensitive to interest rate changes than short term bonds and pricing differences are far more dramatic.
It is for this reason that many investors won’t touch long term bonds right now. Interest rates are being held very low, resulting in a high likelihood of higher rates in the future, which means bonds being issued right now would be worth less. Possibly much less.
Understanding bonds and pricing can be difficult at first glance, so let me know if you have questions with a comment.
The yield takes into account the coupon and the current market value of the bond. So the yield is a way to evaluate bonds based on the pricing information I just detailed above. Remember, coupon and face value never change, but yield does.
Understanding bond yields is essential for investors because the yield is the description of the current value of any given bond investment. There are two commonly used yield descriptions that you will see:
- Current Yield - The current yield considers the current market price of the bond, which, as I mentioned above, may be different from the par value. For example, if you bought a $1,000 par value bond with an annual coupon rate of 6% ($1,000 x 0.06 = $60) on the open market for $800, your current yield would be 7.5% because you would still be earning the $60, but on $800 ($60 / $800 = 7.5%) instead of $1,000.
- Yield to Maturity - Yield to Maturity is the most complicated, but the most useful calculation. It considers the current market price, the coupon rate, the time to maturity and assumes that interest payments are reinvested at the bond’s coupon rate. When you hear the media talking about a bond’s “yield” it is usually this number they are talking about.
Why Investors Own Bonds
You might want to check out my article on common asset classes as a primer.
Bonds offer higher returns than cash equivalents like savings accounts and money market funds, but lower returns than ownership vehicles like stocks (and perhaps real estate). That return is a fairly good reflection of the risk involved in each investment. The greater the risk, they greater the reward.
The most compelling reason to own bonds is their lack of correlation to stock market returns. Bonds tend to zig when stocks zag. This provides a huge benefit to the investor who owns both. It increases diversification and results in a much more stable portfolio.
The fixed interest payments can be a draw to investors as well, although I’d argue against selecting bonds for that reason. Income can be easily generated by stocks by selling shares that have been owned for more than 1 year (or of course owning dividend paying stocks).
Bottom line, most people should own at least a small percentage of bonds in a portfolio. Young investors can make the case for 100% stocks, but many people advocate owning your age in bonds.
As always, investing in a good bond index fund or ETF is a much better solution that trying to pick individual bonds. Diversification and simplicity win.
I hope you enjoyed the article on understanding bonds. Let me know what you think.