What Is a Bond?
What is a bond? A bond is simply a loan. Bonds are issued or sold by companies, agencies, or governments. With a bond, these groups take your investment dollars and promise to pay this money back to you with interest. Bonds are usually priced at $1,000 per bond but these prices fluctuate based on the market.
Let’s use an auto loan as an example. You may decide to take out a loan when you go to purchase a new vehicle from your local car dealership. In this case, the issuer (usually a bank or credit union) provides the money needed for you to purchase your new vehicle and then you will begin making payments on the vehicle until it is paid off
The loan you take out will include terms like the price, length of the loan, and interest rate. These same types of terms also come with bonds. However, in the world of bonds interest rate is referred to as “coupon rate”.
Many people don’t realize that this also works the other way around. You have the ability to invest right back into the company you just bought your vehicle from. You can purchase a bond from a company like Toyota or Honda and these companies will begin making regular payments to you for the length of the loan.
The Benefits of Bonds
No investment is 100% safe but in general, bonds have less risk than many other investment options. Stocks and bonds are usually viewed as polar opposites when considering factors like risk and volatility. While this is not entirely true, bonds are definitely less volatile than stocks.
Bonds provide a consistent source of income. They fall under the category of fixed-income securities because they pay regular and fixed interest payments while you hold the bond. Usually, this interest is paid every 6 months but this could vary depending on the bond.
Investors who hold bonds for the life of the loan (to maturity), will have their original investment returned to them. So if you purchase a bond for $1,000 and the term is 10 years, you will receive interest payments for that bond for the next 10 years. Once the term ends, your bond becomes “mature” and your original $1,000 investment is returned to you.
There is another type of bond that works a bit differently than traditional bonds. Zero-coupon bonds do not pay regular interest.
Investors purchase these bonds at a discount and make their money at the bond’s maturity date when the true value of the bond is returned to the investor. Instead of receiving regular payments during the life of the loan, you receive one lump sum payment at the end of the loan term.
This makes me think of a famous quote by Warren Buffet. “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
Bonds are a way to protect your money.
Some types of bonds, like municipal bonds, also offer additional benefits in the form of tax exemptions on your earnings.
The Drawbacks of Bonds
Although bonds are often viewed as relatively safe investments, there are still some risks that come with bonds. There are five main risks to investing in bonds.
Interest Rate Risk
One of the main risks of bonds has to do with interest rates. There is an inverse relationship between interest rates and bond prices. If interest rates go up then bond prices will fall.
Interest rates change over time and if you are looking to sell a bond before maturity, there is the possibility that you may have to sell the bond at a reduced price. You’d find yourself losing money in this situation.
Government bonds are considered to be zero risk investments because governments have the power to just print money when they need it. That is not the case for all bonds.
Companies can and do default on their loans. In the event that a company goes bankrupt, bondholders will receive any payouts before stockholders. But there is never any guarantee that you will receive any money after a bankruptcy.
The main way to help reduce credit or default risk is to check the credit rating of the issuer before purchasing bonds. There are a few different agencies that rate bonds but typically a AAA rating is given to the highest quality and lowest risk investments.
C and D rated bonds are the lowest quality bonds and these ratings are reserved for high-risk junk bonds.
Some companies may offer higher interest rates to tempt investors into purchasing their bonds. If you see this with a company that has a low credit rating then you may want to do some more research before investing in that company.
It is actually very common for lower-quality companies to offer higher interest rates to attract lenders. Keep this in mind when investing in bonds.
Inflation is something you have to consider with every investment. However, because bonds usually offer a lower rate of return, it is even more important to take inflation into account with bonds. One dollar today is not the same as one dollar a year from now.
If you purchase a bond with an interest rate that is below the current rate of inflation, you are essentially losing money over time.
What if you wanted to sell your bonds but there wasn’t anyone interested in buying? This is called liquidity risk. Most government bonds are frequently bought and sold so there is less liquidity risk with these investments.
But some bonds may be more difficult to buy and sell simply because there are fewer people interested in these bonds. This may not be an issue if you are looking to hold the bond for the entire duration of the loan. But if you think you might consider selling the bond before the loan term is met then you should be aware of the liquidity of the bond.
You don’t want to find yourself unable to sell a bond because there is no market for it.
I refinanced my student loans several years ago because I was able to cut my interest rate in half. I did this because it was a no-brainer and it was in my best interest to do so. Bond issuers may do something similar to this.
If you purchase a bond that is “callable”, then the bond issuer may choose to refinance the loan and pay back your original investment. Although you’ll still receive your original investment back, this would leave you in a situation where you may unexpectedly need to find another investment opportunity.
Why Do Institutions Sell Bonds?
Companies issue, or sell, bonds for the same reason they will often sell stocks. Money. The same goes for governments, agencies, and municipalities.
Companies may issue bonds in order to generate cash for any number of reasons, like buying back their own stock or expanding to new areas and markets.
Governments and municipalities may issue bonds to fund projects like building parks, roads, and schools.
Types of Bonds
There are a few different types of bonds. They all function in a similar way since when it comes down to it, these are all loans. The main difference is who is issuing the loan.
Government bonds are issued by… You guessed it! The federal government. These bonds are most commonly called U.S. Treasuries and are thought to be one of the lowest risk and safest investments you can make because they are backed by the federal government. Treasuries are further broken down by the duration of the loan.
Treasury Bills: Short-term. Bond maturity can be anywhere from a few days to one year.
Treasury Notes: Medium-term. Bond maturity is 10 years or less.
Treasury Bonds: Long-term. Bond maturity is between 10 and 30 years.
Companies issue corporate bonds in order to raise money for their businesses. Corporate bonds typically hold more risk than government bonds but corporate bonds also usually pay a better interest rate than government bonds.
Corporate bonds can be a good opportunity for you to invest in companies you believe are helping to make the world a better place.
Municipal bonds are issued by states, cities, counties, and other government institutions. These types of bonds are often referred to as “munis” and are created to finance projects to improve local communities.
Municipal bonds could be a great investment option for people who desire to help improve the communities around them.
If the city you live in is building a new school and they are issuing bonds to help finance this project then you have the opportunity to support your community while also generating a return on your money.
Municipal bonds don’t seem to get much credit as ESG investments but it’s nice to know that your investment dollars are helping to fund projects like the building of new schools.
Agency bonds may be issued by either:
- U.S. federal government agencies, or
- Government-sponsored enterprises (GSEs)
There is a key difference between the bonds offered by these two different types of agencies. Government agency bonds are backed by the U.S. government whereas bonds from government-sponsored enterprises are not.
The Government National Mortgage Association would be an example of a federal government agency and bonds issued by this organization would be an extremely low-risk investment.
While an entity like the Federal National Mortgage Association (Fannie Mae), may be government-sponsored, it is not truly a government agency so there would be some increased risk with these bonds. You can lessen the risk involved with purchasing GSE agency bonds by reviewing the credit rating of these entities.
International bonds allow you to purchase debt from companies and governments outside of the United States. International bonds have more risks associated with them because information about these bonds may not be as accurate or as readily available. There is also the added risk that the money you invested in an international company may be worth less in the future due to changes in the exchange rates of different countries.
That being said, international bonds could be a good way to diversify your investments and invest in a particular country if that is your goal.
Just like with stocks, many investors choose to invest in bonds through the use of funds. There are a few different fund options for bond investing but the two most common methods are mutual funds and exchange-traded funds (ETFs).
Bond-specific mutual funds and ETFs invest in large numbers of bonds.
Every fund is different and each fund will have different goals. Some funds may only invest in government bonds while other funds may only invest in corporate bonds from large companies. Funds offer an easy way to diversify your investments.
How to Get Started
This article is really only meant to be a brief introduction to bonds. You can go into a lot of depth talking about bond yield curves and the relationship between interest rates and bond pricing. But that is outside of the scope of this article today.
Most online brokers offer a pretty large variety of bond options. My broker has over 75,000 bonds listed. Using an online broker is by far the quickest and easiest way to get started investing in bonds.
Mutual funds and exchange-traded funds are also good options if you’re interested in making just one investment that still allows for a great deal of diversification.
What are your thoughts about bonds as ESG investments? Let me know in the comments below!