Everything You Need to Know About Bonds: Bond Market 101
Let’s start with the basics. What exactly is a bond? A bond is a type of lending strategy where you, the investor, lend money to a borrower. It is what’s known as a fixed income investment, meaning it provides a consistent stream of income for you by relying on a fixed interest rate rather than the motion of the market.
Bonds are commonly compared to stocks because of their ability to diversify your portfolio, but they are more different than they are similar. A stock investment gives you, the investor, partial ownership of the company, whereas a bond does not. Instead, a bond is considered lent money to the borrower, but no form of ownership transaction occurs.
A bond’s stated interest rate, or coupon, is fixed, but another important number is a bond’s yield. Yield is a function of a bond’s market value and the fixed coupon rate. Yield is a measure of the total return of a bond, because it takes into account purchase price, as well as the income stream generated from the interest payments.
The relationship between bond prices and bond yields is inverted — when yields go up , bond prices go down , and vice versa. The benefit is clear: bonds help investors diversify their portfolios without opening them up to too much risk.
Bond Basics
Types of bonds
Financial bonds come in all shapes and sizes, each having their own situational advantages. At a glance, the three major types of bonds include treasury, corporate, and municipal bonds.
Treasury bonds: Treasury bonds are types of debt securities issued by a country’s government to finance its spending or other financial needs. Treasury bonds are generally regarded as low risk investments since they have the backing of the federal government.
Corporate bond: Corporate bonds are issued by corporations to raise capital for various purposes, such as funding expansion plans, acquiring new assets, or refinancing existing debt. When investors purchase corporate bonds, they are essentially lending money to the issuing corporation in exchange for regular interest payments and the return of the principal amount at maturity.
Municipal bond: Municipal bonds are issued by state and local governments, municipalities, and other governmental entities. Generally, the purpose of issuing municipal bonds is to raise funds for public projects, such as building schools, roads, bridges, or financing public infrastructure.
Credit ratings, bond yields, and returns
Similar to any other type of loan, credit ratings play a big part in establishing any of these three types of bonds. When a bond is issued, it receives a credit rating from rating agencies, which helps evaluate the creditworthiness and the likelihood of default by the issuer. The credit rating can influence a number of factors within the bond agreement, most notably the interest rate and the date that the principal is due. In turn, this affects what is called the bond yield or bond return — the amount collected by the investor solely from interest charges. Each bond is constructed differently by underwriting, so it is important for both the lender and lendee to take note of their contract’s details and ensure it is constructed in a way that is beneficial to them and their goals.
How do bonds work?
The construction of bonds can be highly technical, depending on the parties involved and the amount of money tied up within the agreement. Having said that, here is a high-level process that can be generally followed to help you understand the bond process:
Issuing bonds
Simply put, bonds are issued by governments and corporations to help raise money. In biology, we would refer to a bond as a symbiotic relationship, as it helps both parties involved — the lender gets rewarded through bond yields and the lendee gets rewarded with liquidity they otherwise wouldn’t have.
Bond pricing
The pricing of the bond depends on a number of factors, including the lendee’s credit rating, the interest rate, the maturity of the bond, and simple supply and demand metrics. When all of these factors are considered, both parties involved will come to a bond price that suits both of their interests.
Bond maturity and coupon rates
The maturity of a bond refers to its age (i.e., how long the bond has been active). Maturities can range from short (<1 year), to medium (1-10 years), to long-term (>10 years). Over the lifespan of a bond, the lender will get paid interest in what’s known as coupon rates until the bond is paid to its full maturity.
How to invest in bonds
Benefits of investing in bonds
The primary benefits of investing in bonds speak to their reliable and steady nature — two important elements that help combat a volatile economy. First, bonds are a fixed-income investment, meaning they provide regular coupon payments to bondholders. This can be attractive for those seeking a stable and predictable income stream, especially in an unpredictable economy.
Secondly, investing in bonds can help raise the value of your portfolio by diversifying your types of investments — and, when combined with stocks and other asset classes, bonds can help reduce overall portfolio risk.
Risks of investing in bonds
Bonds do come with their own set of perils you should consider before investing. Bonds are sensitive to changes in interest rates. When interest rates rise, the value of existing bonds typically falls, as new bonds with higher interest rates become more attractive.
The same concept applies when interest rates decline as the value of existing bonds tends to rise. Additionally, not all bonds are highly liquid, meaning they may be difficult to sell quickly at a fair price. We refer to these bonds as “illiquid bonds,” which may result in delays or less favorable prices when trying to sell.
Determining bond allocations in a portfolio
After balancing the benefits and risks of investing in a bond, you may decide to pursue it. The next step in the process would be determining the bond allocations in your portfolio. Your financial advisor can help you to:
1. Define investment objectives and assess risk tolerance.
2. Determine the time horizon for your portfolio.
3. Evaluate asset allocation by considering the optimal mix of assets.
4. Understand bond characteristics, such as duration, credit quality, yield, and maturity.
5. Consider diversification by allocating funds across different bond sectors, regions, industries, and maturities.
Want to learn more about investing in bonds?
That’s why we’re here. We’ll help you determine whether or not investing in bonds makes sense for your portfolio and where to begin in the process. Our financial advisors can guide you to help you better navigate the bond market and how to align them to your long term financial plan.
