Investing in Bonds 101—What Bonds Are & How They Work

Bond Investing 101

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Bonds are a type of fixed income investment in which the bond issuer borrows money from an investor, in exchange for a payoff at a given time down the road. The investor receives the bond and, in the case of your standard basic bond, a promised schedule of interest payments, called coupon payments. Bonds also come with a date when the loan will be repaid in full, known as the maturity date. 

When you buy a bond, you are loaning money that the issuer uses to invest. Since bonds are among the safest of assets, by the time your bond has matured, chances are you can cash it in for more than you paid. That's the simple version, but there's much more to know if you want to invest in bonds like a pro.

Why Invest in Bonds?

One of the main appeals of bonds, from the point of view of the bond issuer, is that they lower the cost of capital. For example, think of a growing business with a high return on assets, such as a retail store that is opening new branches at a rapid pace. By using borrowed money on fair terms, the company can open more branches sooner than would be possible by getting a loan from a bank. 

This leverage increases their return on equity (ROE), or how much of the loan money they were able to convert into income.

The Dupont Model of Return on Equity offers data about how a venture creates gains from capital it receives. It measures the net profit margin, the asset ratio, and uses a basic factor multiplier, to provide not only a figure for ROE, but also insight into its causes.

How Are Bonds Issued?

Bonds can be issued by all sorts of public and private firms, institutions, and governments. These include Federal governments (which issue what are known as sovereign bonds, or in the U.S. that means Treasury bonds and savings bonds); state governments (which issue what are known as municipal bonds); corporations (which issue corporate bonds); and many more. 

There are many types of bonds, with a wide range of traits to be found. Some bonds are given at a discount and mature at full value. These are known as "zero coupon bonds." Other bonds have special perks attached to them. "Convertible bonds," for instance, allow you to convert them into common stock on preset terms, on certain dates, and at set prices. These types of bonds are a close cousin to convertible preferred stock.

How Are Bonds Rated?

Bonds are rated by bond rating agencies. At the top of the ratings are so-called investment grade bonds, with Triple A rated bonds being the best of the best. At the bottom are junk bonds. As a rule, the higher the grade, the lower the interest rate yield because there is less perceived risk involved in owning the bonds. In other words, the chances are thought to be higher that you will be repaid, both principal and interest, on time and in full.

Bonds often compete with other safe assets such as money market accounts, money market funds, certificates of deposit, and savings accounts. Investors are drawn to those which seem to offer the better tradeoff between risk and yield at any given moment. Each has its own benefits and drawbacks, but for the most part bonds suit those looking for passive income, and don't want to worry about the ups and downs that come with owning stocks, or in a shifty pricing market as with real estate.

The Risks of Bonds

One major risk in the quest to make money from bonds is inflation. The money you gain by the time the bond matures, or the rate at which it grows, should be great enough to combat inflation and protect against eroding your purchasing power. Some bonds, such as Series I savings bonds and TIPs have at least some degree of built-in immunity from inflation. But investors don't always behave in the most rational way. 

If you doubt this, look at what happened not that long ago in Europe. Fixed income investors were buying 50- and 100-year bonds at historically low interest rates. The long term bonds combined with the low rates all but guaranteed that, once the bonds matured, they would lose almost all of their purchasing power.

It's a crazy way to behave but people have been known to act against reason when money is the lure, reaching for yield when they should be content to sit on cash reserves instead. 

For this reason, bonds are not always safer than stocks when you begin to look at the bigger picture (rather than honing in only on volatility in a silo).

Investment Decisions

There are many factors to weigh when trying to figure out how much of your portfolio you should allot to bonds. Strategies will differ from one investor to the next, such that a smart bond purchase for one person may be unwise for another. These choices can be influenced by a range of factors, from risk tolerance, to investable assets to market alternatives available at any given moment. 

People who invest at a smaller scale tend to invest in bond funds to attain better diversification. This is because single bonds most often need to be bought in blocks of $5,000 or $10,000 at a time to secure a good price. You may be able to get away with $2,000 or $3,000 if you are buying from a low-cost broker with a lot of bond liquidity on hand in the issue you are looking at. But you'll get a much better price the larger the block you purchase. 

This is the reason asset management firms, advisors, and financial institutions tend to have higher minimum investments for clients who want to have managed accounts, and for these to focus on fixed income securities. (By way of example, at my asset firm, through which I will manage my own family's wealth along with the wealth of high net worth clients, we're planning on setting the minimum for fixed income accounts at $500,000 or more.) 

On the upshot, in this period of low interest rates, fees on fixed income accounts are often much lower than on equity accounts. It is quite normal to see managed bond accounts with fees ranging from 0.50% to 0.75% for accounts worth between $1 million and $10 million.

Capital Preservation

A large number of bond investors aim for a mandate known as capital preservation. That is because money put into bonds tends to be irreplaceable capital. As the name suggests, this is money that can't be earned back easily, such as that earned from the sale of a family business after years, decades, or generations of work. Or, it may be wealth earned from a short but highly lucrative career (such as that of a professional athlete). Or it may be inherited. This form of capital may also come from earnings over a lifelong career, at a time when the bond investor is too old to work again, or of poor health, and not able to make the money back should it be lost. 

From time to time, other types of investors are lured by the bond market as well. These are often well-meaning novice types who employ leverage to buy speculative junk bonds. The appeal here is that they can make a lot of money in a short amount of time. But junk bonds carry a major risk of blowing up and losing value, so many learn the hard way that this type of investment is really more like a gamble.

Advantages of Bonds

All in all, there are many unique advantages that bonds offer their owners. One is the ability to precisely time cash flow. By building bond ladders and buying bonds with certain scheduled coupon payment dates, you can help ensure that a cash payout will come at the precise time you need it. 

Also, certain bonds have unique tax aspects. as the interest earned on bonds is exempt from taxes. 

The perks of investing in municipal bonds, for instance, are vast. Not only do you provide funding to build your local community (through schools, hospitals, sewers, bridges, roads, social service programs, etc.), but, so long as you follow the rules and purchase the right type of bond based on where you live, you should be able to enjoy tax-free income as well.

Be sure to pay close attention to asset placement, as this can affect your taxes in subtle ways, or negate the tax perks of other tax-advantaged accounts. For example, you should never hold tax-free municipal bonds through a Roth IRA.