Many beginning investors and even some moderately experienced investors may have issues with understanding the exact workings of bonds and the bond market as a whole. The bond market may be intimidating, but it doesn’t have to be. Understanding a few key concepts and a little bit of terminology will help you navigate the ins and outs of bond investing.
Bonds are simply a way for governments and companies to borrow money. Instead of seeking financial resources from a bank or other lending facilities. These institutions can seek to sell bonds to a large group of investors in an attempt to raise the necessary capital it requires to operate or grow. Typically, issuing a bond can be less expensive than a bank loan and tends to offer more flexibility.
For the investors, it’s helpful to just think of yourself as a lender when you invest in bonds. Investors buy bonds from the company/government that issues them, and the company/government promises to pay back investors the principal amount plus interest. Interest payments are paid regularly (usually quarterly, semi-annually or annually) until the bond “matures” or reaches the end of its agreed term.
Bonds are issued in varying terms of lengths, they may mature in the very short term (days or months), short term (one to five years), medium term (six to 10 years) or even long term (more than 12 years). Typically, the longer the term of the bond, the higher the coupon rate. The coupon rate is the key indicator to the investor on the amount of interest he or she will get over the life of the bond. For example, a bond with a 5% coupon rate and a $1,000 face value will pay the bondholder $50 each year.
Bonds also have a credit rating based on how likely they are to be paid back in full. These may vary between different bonds, but they generally range from AAA for the highest quality bonds down to D for bonds in default or non-payment.
The lower the credit rating, the higher the risk of default. For the investor, this can also translate to taking on higher potential returns for taking on more risk.
How the Initial Bond Market Works
Bonds issued in primary markets are similar to a company’s initial public offering (IPO) of stock. Companies looking to raise money via bonds coordinate with investment banks to set the coupon rate, the terms of the issue and the total amount of money the company is going to raise.
The investment banks then sell the bonds usually to large institutional investors (who make up the bulk of bond buyers) through an initial offering. These bonds are issued by the borrowing company at an offering price that is uniform for all investors. This standard price is known as the par value, which is usually $100.00 per bond. However, it is also important to note that it is common for a company to issue bonds at a discount (for example, selling a $100.00 bond for $99.50) or at a premium (for example, selling the instrument at $100.10 which constitutes as above par).
After the initial offering, investors may buy or sell bonds on the secondary market through brokers. Think of a secondary market like a used-car market, where once “new” bonds are sold secondhand to other investors.
Secondary markets are much more accessible to smaller investors, and you don’t have to be an investment banker to take part. However, it’s vital that investors understand how bond prices move when interest rates change. As a rule, when interest rates rise, bond prices fall. The opposite is true as well — as interest rates decline, bond prices increase.
However, the change in interest rates impact bonds differently depending on many factors, including time to maturity. Individual bond investing can at times be more complex and requires much more diligence and research than stock investing.
As with all investments, it is important to assess risk when purchasing bonds. Analyzing the price, interest rate, yield, redemption features, taxation and the company’s credit history and rating when weighing which bond to choose.
Investing in individual bonds can also at times be expensive, especially if you desire to buy several different bonds to create a diversified portfolio. Many bonds are associated with minimum buy in amounts and this can range from around (but are not limited to) $2,000 USD up to $200,000 USD.
Bond Exchange-Traded Funds
For those interested in a bond investment with lower expenses, a bond ETF makes a great alternative investment. These securities may hold/ track the performance of several bonds, diversified by term/ market segment, credit risk, and/or type.
Bond ETFs are much like stocks in that they are traded on the stock exchange. Similarly to stocks, bond ETF prices fluctuate with demand and may also be sold at any time.
As the characteristics of stocks & bonds differ, both can yield a number of benefits for clients, but most importantly it is about matching your investment strategy/ goal and risk attitude with a proper mixture of securities.