Whoopty flipping do a whole week devoted to bonds? I promise I will do my best to keep you awake as we explore this important investment type. In the coming week we’ll start with learning what a bond is, different types of bonds, why you might want to include them in your investment portfolio and how to choose a bond.
What is a Bond?
Simply put a bond is a loan to the issuer. In essence you become the lender in exchange for regular interest payments over the term of the loan to the bond issuer. A bond issuer could be a variety of sources such as corporations, governments or local municipalities like your city or schools. These payments are usually paid twice a year and once the bond reaches it’s maturity date (end date) you will receive back the initial value of the investment. So when your local city government needs some money for a road project for instance they can’t just go down to the local bank and borrow twenty million dollars rather they’ll issue a bond and offer it to investors over a pre-determined length of time.
How does a Bond Work?
When you purchase a bond you are buying it at it’s face value (also referred to as the par value). So I buy a bond for a $1000 it has a face value of…shocking a $1000. Like a ticket to the Olympic games the value someone else wants to pay for that bond can fluctuate depending on a variety of conditions such as the event and who’s competing in that event. Same for bonds. If you just decide to hold on to your bond for the duration of it’s term, you’ll receive the face value of that bond at the end. But hold on I could bury my money in the back yard and get the same amount at the end. True, but I mentioned that a bond is an “investment” so there is the presupposition that you will actually make money on your investment. Let’s look at how you can do that.
The rate of return of your bond is called the coupon rate. It’s the rate of interest payable on the bond calculated yearly. This rate is set when the bond is issued and for most purposes does not change. Typically you’ll receive interest payments twice a year with few exceptions. Here’s where your making your extra money. The amount of your coupon rate is based on risk.
Finally the last bond component we’ll talk about is the maturity date. This is the deadline by which you are owed the face value of your bond, or when the hockey game starts to follow our example. Once this date is reached, that’s the end of this bond and you’ve got to find something else to do with your money.
The Kevin Bacon of Investments
Think about the bond and you most always here it combined with stocks. Stocks and bonds, peas and carrots. They typically go together for good reason. Think of a bond like Kevin Bacon. He’s moderately famous, he’s had good success but he’s not the flashy star of blockbuster movies. You may argue that Footloose was his shining moment but I don’t think anyone will admit that in public. Rarely will you ever hear talk of bond investing as a primary investment strategy but it rounds out your portfolio very well by balancing risk. By the way Kevin if you are reading I mean no offense you were great in a Few Good Men and Planes, Trains and Automobiles.
Risk and Reward
Why it’s not likely that you are going to be retiring early off your stable bond funds, that’s exactly the point. You are working with a fixed rate of return with a relatively known risk. Like most investment choices the higher the risk the higher the reward. A bond is similar to a stock in that regard but there are some methods you can use to determine how risky a bond is going to be. The risk is tied directly to the return of the bond. Think about your credit score and how that impacts the interest rate you can get on a home mortgage. The same goes with bonds, have a sketchy company issuing a bond, the rate of return is going to have to be higher to actually get people to loan them money, but the chance they are going to go south is high as well. This would be the risk of default or the chance that the entity issuing the bond might not be around to fulfill the obligation to pay back the bond.
Interest Rate Risk
A second area of concern is the risk based on the current interest rate. Bonds will fluctuate with changes in the market rates of interest moving in the opposite direction. Interest rates rise and bond prices fall. People investing later in the game will want to take advantage of the higher yield that a larger interest rate will bring so your bond will not bring as much if you sell it before the maturity date. What? This makes no sense! We’ll talk about this more later in the week along with some suggestions on how you can minimize that risk.
Fortunately you don’t have to just guess at the performance of a particular bond there are comprehensive rating systems in place to help you research your investments. Moody’s and Standard & Poor’s are two of the largest rating agencies all loosely based around an AAA or Aaa to C or D rating. The lowest risk and best rated choices would be Aaa from Moody’s and AAA from Standard & Poor’s. There are two classes of bonds: Investment Grade which would refer to a bond Baa/BBB or better and High Yield below Baa/BBB. You may know the High Yield bond by it’s vanity name junk bond.
Enough for Now
Hopefully your eyes aren’t bleeding and come on back tomorrow for our exciting continuation looking at Savings Bonds. Hold on to your hats!