How bonds work
Bonds are fixed-income instruments issued by companies, municipalities, states, the federal government and other entities to raise funds by borrowing from investors. When you purchase a bond, you lend an organization money for a fixed period of time, typically at an agreed-upon interest rate.
That interest is how you make money on your bond until it matures. You can also make money by selling your bond for a higher price than you paid for it.
Stocks (or equities) represent stakes in a company measured in shares. In contrast, bondholders become creditors by purchasing the debt of a bond issuer. They usually receive an agreed-to interest rate in return, called the coupon rate.
Coupon rates are based on the price of the bond when it is first issued, aka the “face value” of the bond. The face value of a bond may differ from the market value. For example, a bond with a $1,000 face value may be trading on the secondary market at a premium of $1,050 or a discount of $950.
Bondholders generally receive interest payments until the bond reaches maturity, at which point the bond issuer repays the bond’s face value. The return you realize on a bond is known as its bond yield.
How do you know the value of a bond?
While the face value is fixed until a bond reaches maturity, a bond’s current market value can change. This is essentially a consequence of fluctuating interest rates and other events after issuing a bond. Here are the major factors that determine the market value of a bond:
- Interest rates — Bond prices typically fall when interest rates rise, and vice versa.
- Market conditions — If the stock market is doing well, investors may move out of bonds and into the market. If it's a bear market, investors may move out of bonds into the market.
- Maturity — Bond prices tend to move closer to their face value as their maturity date approaches because the bondholder is closer to receiving that face value.
- Creditworthiness — If a credit agency downgrades a bond, it signals that the issuer's creditworthiness is falling and will likely decrease the price of the bond.
What are the different types of bonds?
Many organizations issue bonds, from financial institutions and corporations to governments/ government agencies and municipalities. Below are the four major types of bonds:
Treasury securities are issued by the U.S government and periodically pay a fixed interest rate until they mature. Since they are considered risk-free, they usually offer the lowest interest rates compared to other bonds. Federal government bondholders are generally exempt from paying state and local taxes on interest.
States and municipalities issue bonds to raise funds for projects to promote the public good. In some cases, municipal bonds offer investors tax-free coupon income. Municipal bonds are not considered to be quite as safe as treasury bonds because local governments can go bankrupt and put bondholders at risk of loss.
Corporations issue bonds for various purposes, such as funding a specific project or raising capital for operations. Corporate bonds pay a higher interest rate than treasuries because no corporation is as creditworthy as the government. The creditworthiness of corporate bonds can vary widely depending on the underlying company.
Entities that are at high risk of default may issue junk bonds. While investors may not get their principal back if they invest in junk bonds, they're typically paid high interest rates to compensate for the associated risks.
What are the benefits of investing in bonds?
While different bonds have different characteristics, some general benefits apply to most bonds. Most bonds are:
- Less risky than stocks. Bond issuers return the face value to the bondholder at maturity. While individual bonds and bond funds can default, they are still generally less risky than investing in a stock.
- Able to offer fixed income. Bonds can offer fixed interest rates, which are generally more reliable than dividends from stock.
- Helpful in executing a ladder strategy. You can purchase multiple bonds with fixed income rates, each with maturity dates spaced out over time to give you a consistent income. This strategy, called laddering, creates a continuous stream of passive income.
Which bonds are good for a retirement portfolio?
Reliable fixed-income investments, like Treasury bonds, can be appropriate for a retiree because they offer consistent interest payments, tax exemptions, and are virtually risk-free from principal loss. If an investor has higher risk tolerance, high-grade corporate bonds can likely provide a better interest rate than treasuries with an incremental increase in risk.
What are the risks associated with investing in bonds?
While government treasuries are considered virtually risk-free, not all bonds are free from risk. Understanding the various risks of investing in bonds will help you assess where to allocate your capital.
Interest rate risk
If interest rates rise, the price of a fixed interest rate bond will decline. This is because potential buyers can purchase a newly-issued bond at a higher interest rate.
Bonds with a long-term maturity are often locked into their interest rates. This is risky because investors are still locked into the lower interest rate from when they bought the bond if interest rates rise. Long-term bond issuers try to compensate for this risk by offering higher interest rates than short-term bonds.
Related: Which investing sectors are affected by interest rates?
The general market impacts bonds. If the stock market rises, then the value of bonds could drop as people exit bonds to enter the stock market. Additionally, a high inflation environment (like we're in right now) will progressively diminish the purchasing power of your coupon payments.
The creditworthiness of the bond issuer
The creditworthiness of a bond issuer has a significant impact on the risk of a bond. A corporation can be creditworthy when the bond is purchased and then lose credibility over time until the investment is downgraded to junk bond status.
This puts the bondholder in a difficult position, as they would likely take a heavy discount if they were to sell immediately. On the other hand, there is no guarantee that the bondholder will continue receiving interest payments or get the principal back.
How much of my portfolio should I invest in bonds?
One rule of thumb says that the percentage of your portfolio you should allocate to stocks is 120 minus your age. The rest should be invested in low-risk assets such as bonds.
For example, someone 40 years old would allocate 80% (120-40 = 80) of their portfolio to stocks and 20% to bonds. But this rule of thumb doesn’t consider personal circumstances or market conditions. For example, in a low-interest-rate environment, retirees may decide to allocate a larger portion of their portfolios to dividend stocks instead.
Therefore, this rule is more of a general guideline. Your asset allocation to bonds will be a function of your risk tolerance and financial goals. Your risk tolerance may fluctuate based on your age, job, and other personal circumstances.
How to buy bonds
You can typically purchase bonds through brokerage firms or buy treasuries directly from the U.S government. However, there are many ways to gain exposure to bonds.
Individual bonds — Buying bonds individually through the primary or secondary market is the most direct way to get exposure. However, the downside is that you only have exposure to each bond you buy. This can be risky if the bond issuer suddenly faces financial distress.
Mutual funds — Some people prefer buying bonds through mutual funds because this option offers greater diversification. However, a downside of mutual funds is that they charge management fees that can eat into your returns.
ETFs — Bond exchange traded funds (ETFs) usually invest in various fixed-income securities. Since many ETFs passively follow benchmark indexes, they're likely to have lower fees than actively-managed mutual funds.
Robo-advisors — A robo-advisor will build you a custom portfolio that matches your age and risk tolerance and will automatically adjust your asset allocation over time. So your portfolio's bond holdings will gradually increase as you get closer to your target date. Compare the top robo-advisors here.
When is the best time to buy bonds?
The best time to buy bonds is when you believe interest rates are about to fall. As mentioned earlier, when interest rates fall, the value of a bond increases. However, for those who need a fixed income stream, the best time to buy a bond may be whenever they find a bond that has a satisfactory coupon rate and creditworthiness.
Are bonds a good investment?
Bonds are an excellent investment for anyone who desires reliable fixed income from coupon payments and has a low tolerance for risk. Regardless of your age, bonds can have a place in your portfolio.
With that said, interest rates are currently at historic lows. For example, in March 2020, the yield on the 10-year treasury dipped beneath 1% for the first time ever due to the pandemic. While interest rates have risen since then, they are still low compared to historical rates as the chart below shows. Low interest rates coupled with inflation are a cause for concern when you consider long-term, fixed-rate bonds.
Even though bonds are less attractive in the current environment they can still be useful. For example, if you have excess cash that you won’t need in the near future, investing in bonds is still likely more attractive than just putting your cash in a savings account.
Additionally, the Fed has already started raising interest rates in 2022, which could make bonds more favorable over time. Higher interest rates affect stock valuation as investors are less willing to invest in risky assets if they can achieve an acceptable return in fixed income securities.
The bottom line
Bonds, as part of a diverse portfolio, can act as a balance to one’s more risky assets. Investors often use them to produce a fixed income stream. Investors also ladder bonds to manage liquidity and cash flow.
Bonds have been less attractive in recent years due to the low interest rate environment and growing concerns of inflation. However, as interest rates rise, the appetite for bonds may grow as more investors find coupon rates attractive.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.