What You Need to Know About Bonds

Bonds can create a more balanced portfolio by adding diversification and calming volatility. But the bond market may seem unfamiliar even to the most experienced investors.

Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the bond market and the terminology. In reality, bonds are very simple debt instruments. 

Key Takeaways

• The bond market can help investors diversify beyond stocks.
• Some of the characteristics of bonds include their maturity, their coupon (interest) rate, their tax status, and their callability.
• Several types of risks associated with bonds include interest rate risk, credit/default risk, and prepayment risk.
• Most bonds come with ratings that describe their investment grade.

Basic Bond Characteristics 

A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value. The company pays the interest at predetermined intervals (usually annually or semi-annually) and returns the principal on the maturity date, ending the loan.

Unlike stocks, bonds can vary significantly based on the terms of their indenture, a legal document outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important features to look for when considering a bond. Bonds are a form of IOU between the lender and the borrower.

There Are Three Types of Bonds: 

Corporate Bonds 

Corporate bonds refer to the debt securities that companies issue to pay their expenses and raise capital. The yield of these bonds depends on the creditworthiness of the company that issues them. The riskiest bonds are known as “junk bonds,” but they also offer the highest returns. Interest from corporate bonds is subject to both federal and local income taxes.

Sovereign Bonds 

Sovereign bonds, or sovereign debt, are debt securities issued by national governments to defray their expenses. Because the issuing governments are very unlikely to default, these bonds typically have a very high credit rating and a relatively low yield.

Municipal Bonds 

Municipal bonds, are bonds issued by local governments. Contrary to what the name suggests, this can refer to state and county debt, not just municipal debt. Municipal bond income is not subject to most taxes, making them an attractive investment for investors in higher tax brackets.

Key Terms:

Maturity 

This is the date when the principal of the bond is paid to investors and the company’s bond obligation ends. Therefore, it defines the lifetime of the bond. A bond’s maturity is one of the primary considerations an investor weighs against their investment goals and horizon.

Maturity is often classified in three ways:

• Short-term: Bonds that fall into this category tend to mature within one to three years
• Medium-term: Maturity dates for these types of bonds are normally over 10 years
• Long-term: These bonds generally mature over longer periods of time

Secured/Unsecured 

A bond can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company cannot repay the obligation. This asset is also called collateral on the loan. So, if the bond issuer defaults, the asset is then transferred to the investor. A mortgage-backed security (you may remember 2008 housing crisis – these were packaged as good investments on bad loans/mortgages by the big banks) is a type of secured bond backed by titles to the homes of the borrowers.

Unsecured bonds, on the other hand, are not backed by any collateral. That means the interest and principal are only guaranteed by the issuing company. Also called debentures, these bonds return little of your investment if the company fails. As such, they are much riskier than secured bonds.

Liquidation Preference 

When a firm goes bankrupt, it repays investors in a particular order as it liquidates. After a firm sells off all its assets, it begins to pay out its investors. Senior debt is debt that must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.

Tax Status 

While the majority of corporate bonds are taxable investments, some government and municipal bonds are tax-exempt, so income and capital gains are not subject to taxation. Tax-exempt bonds normally have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.

Risks of Bonds 

Bonds are a great way to earn income because they tend to be relatively safe investments. But, just like any other investment, they do come with certain risks. Here are some of the most common risks with these investments.

Interest Rate Risk 

Interest rates share an inverse relationship with bonds, so when rates rise, bonds tend to fall and vice versa. Interest rate risk comes when rates change significantly from what the investor expected. If interest rates decline significantly, the investor faces the possibility of prepayment. If interest rates rise, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future.

Credit/Default Risk 

Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required. When an investor buys a bond, they expect that the issuer will make good on the interest and principal payments—just like any other creditor.

When an investor looks into corporate bonds, they should weigh out the possibility that the company may default on the debt. Safety usually means the company has greater operating income and cash flow compared to its debt. If the inverse is true and the debt outweighs available cash, the investor may want to stay away.

So, Are Bonds Risky Investments?

Bonds have historically been more conservative and less volatile than stocks, but there are still risks. For instance, there is a credit risk that the bond issuer will default. There is also interest rate fluctuations. 

Changes in the bond market can have significant impacts on the economy:

• Bond prices and interest rates have an inverse relationship when bond prices fall, interest rates rise, and vice versa. This relationship affects borrowing costs for businesses and individuals. When bond yields rise, it becomes more expensive for companies to borrow money, which can slow down business expansion and economic growth. Conversely, when bond yields fall, borrowing costs decrease, which can stimulate economic activity.
• Inflation expectations: Bond prices are sensitive to changes in inflation and inflation forecasts. If market participants believe that there is higher inflation on the horizon, interest rates and bond yields will rise to compensate for the loss of the purchasing power of future cash flow. This can impact the economy by affecting consumer spending, business investment, and overall economic growth.
• Investor confidence and risk appetite: Bond yields can be an indicator of investor confidence and risk appetite. During “boom” times, investors require less incentive to hold risky assets, so the spread between the yields of risky bonds and Treasuries declines. Conversely, when investors’ confidence level is low, the demand for Treasuries will increase, hiking up Treasuries’ prices and lowering their yields. These changes in investor sentiment can impact the availability of credit and the overall functioning of the financial system.
• Wealth effect: Changes in bond prices can also impact consumer wealth and spending. When bond prices rise, the value of existing bonds held by investors increases, which can lead to a wealth effect and increased consumer spending. Conversely, when bond prices fall, the value of existing bonds decreases, which can reduce consumer wealth and spending.
• Impact on financial institutions: Changes in bond prices can have a significant impact on financial institutions, particularly those that hold a large amount of bonds in their trading books. A rise in government bond yields can lead to unrealized losses for banks, which can affect their balance sheets and lending capacity. This, in turn, can impact the availability of credit and the overall functioning of the economy.

In summary, changes in the bond market can have far-reaching effects on the economy, including interest rates, borrowing costs, inflation expectations, investor confidence, consumer spending, and the financial health of institutions. Which is what we have experienced in the last couple of months with the markets. 

So, what does it mean?

Only Time Will Tell… Some believe this is where we begin a run others predict doom and gloom… Which ever way you look at it there is always something else on the horizon.