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Bonds

When you think about bonds, you might think about a certificate your grandparents gave you for your birthday when you were young.

Bonds
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July 5, 2022

When you think about bonds, you might think about a certificate your grandparents gave you for your birthday when you were young. And maybe you were like, huh? But they were actually doing you a favor by introducing you to investing! In the haze of your remember-I-asked-for-an-ipod-grandma disappointment you just didn’t know. While stocks are equity securities, bonds are debt securities.‍

A bond is a debt obligation from an institution to you. Think of a mortgage. The lender gives you a loan for $600,000 in exchange for monthly payments which include interest. Bonds work in a similar fashion except you are the lender. Companies, municipalities, states and the federal government use bonds to pay for property or equipment or fund projects or research and development. An example would be a bond used to raise money to build a bridge. The city of San Francisco needs to raise $3 billion to build a bridge. To do that they will take money from us in the form of a municipal bond in exchange for regular interest payments. You will then receive the entire principal at the end of a given time period.

How bonds work

The following are the characteristics of a bond:

  • Issue Price: The price at which the bond is purchased by the buyer‍
  • Coupon Rate: The interest rate the bond will pay
  • Coupon Dates: The dates the interest will be paid
  • Maturity Date: The date upon which the bond matures ‍
  • Face Value: The value of the bond at maturity

The price of bonds are based on their individual characteristics. The price will change in response to changes in interest rates. As interest rates go up, the price of bonds goes down and vice versa. This is because, since most bonds pay a fixed interest rate, if interest rates rise the demand for bonds will fall because the lower interest rate will no longer be attractive. Conversely, if interest rates decline, the bond’s rate is more appealing and the demand will drive the price up.

The coupon rate of the bond is largely determined by the creditworthiness of the issuer and the time to maturity. The lower the credit of the issuer, the higher the interest rate because the default risk is higher. Bonds with longer maturity have higher interest rates than shorter ones because the inflation and interest rate risk is greater.

Interest is usually paid semiannually on bonds. For example, for a bond with $1,000 face value and 5% coupon rate, you would receive $50/year or $25 every 6 months. 

The maturity date is the date when the repayment of the principal is due to the investor. Bonds generally have maturity dates anywhere from 1 to 30 years.

Types of bonds

There are several types of bonds categorized by the issuer:

  • Treasury Bonds: Treasury bonds are one of the four kinds of debt issued by the U.S. Treasury for the purpose of funding federal government spending. Their maturities range from 10 to 30 years and they pay a fixed interest rate on a semiannual basis. Interest is taxed on the federal level for treasury bonds.‍
  • Other Government Bonds: These are also known as agency bonds and are issued by government agencies like Fannie Mae, Freddie Mac, and Federal National Mortgage Association. Interest is taxed on the federal and state level.
  • Investment Grade Corporate Bonds: These are issued by companies with a BBB or higher S&P rating. They have low risk of default, but higher than government bonds so the interest rates are higher for these types of bonds.‍
  • High-Yield Bonds: High-yield bonds are also issued by companies, but because of the issuers low rating (below BBB), they pay a higher interest rate. These are also known as junk bonds.
  • Municipal Bonds: Municipal bonds are issued by lower levels of government like municipalities, cities or states to fund projects and improvements. These are exempt from federal taxes and most of the time state taxes as well.
  • International Bonds: An international bond is issued by a foreign entity in a domestic market, usually in that entity’s currency. 
  • Mortgage-backed Bonds: A mortgage bond is secured by a mortgage, or a pool of mortgages, hence making the security more secure.

 There are also a few different varieties of bonds, varying by interest rate or other attributes.

  • Zero-coupon bonds: As the name implies, zero coupon bonds do not pay interest. Instead, they are bought at a discount and a profit made at maturity when the face value paid is greater than the issue price. 
  • Convertible bonds: Convertible bonds pay interest, and can be converted into common shares of the issuer. The time of conversion is usually decided by the investor.‍
  • Callable bonds: Callable bonds have a feature in which the issuer can “call” the bond, meaning they can pay off bondholders before maturity. This is usually done if interest rates fall below the coupon rates of the bonds and the issuer can call the bonds and reissue bonds at a lower interest rate.‍
  • Puttable bonds: Puttable bonds are kind of the opposite of callable bonds. They allow the investor to sell the bond back to the issuer before maturity.

How do I invest in bonds?

There are different ways to invest in bonds. It’s important to understand the basics of investing and we’ve created an intro to help you get started.

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David Barta, CFA, CFP®