What Bonds Are and How They Work
Bonds are loans made to large organizations. These include corporations, cities, and national governments. An individual bond is a piece of a massive loan. That’s because the size of these entities requires them to borrow money from more than one source. Bonds are a type of fixed-income investment. The other types of investments are cash, stocks, commodities, and derivatives.
There are many different types of bonds. They vary according to who issues them, length until maturity, interest rate, and risk. The safest are short-term U.S. Treasury bills, but they also pay the least interest. Longer-term Treasurys, like the benchmark 10-year note, offer slightly less risk and marginally higher yields. TIPS are Treasury bonds that protect against inflation. Municipal bonds return a little more but are riskier. Corporate bonds have more risk. The highest paying and highest risk ones are called junk bonds.
How Bonds Work
The borrowing organization promises to pay the bond back at an agreed-upon date. Until then, the borrower makes agreed-upon interest payments to the bondholder. People hold own bonds are also called creditors or debtholders. In the old days, when people kept paper bonds, they would redeem the interest payments by clipping coupons. Today, this is all done electronically.
Of course, the debtor repays the principal, called the face value, when the bond matures. Most bondholders resell them before they mature at the end of the loan period. That's because there is a secondary market for bonds. Bonds are either publicly traded on exchanges or sold privately between a broker and the creditor. Since they can be resold, the value of a bond rises and falls until it matures.
Bonds pay off in two ways. First, you receive income through the interest payments. Of course, if you hold the bond to maturity, you will get all your principal back. That's what makes bonds so safe. You can't lose your investment unless the entity defaults.
Second, you can profit if you resell the bond at a higher price than you bought it. Sometimes bond traders will bid up the price of the bond beyond its face value. That would happen if the net present value of its interest payments and principal were higher than alternative bond investments.
Like stocks, bonds can be packaged into a bond mutual fund. Many individual investors prefer to let an experienced fund manager pick the best selection of bonds. A bond fund can also reduce risk through diversification. This way, if one entity defaults on its bonds, then only a small part of the investment is lost.
Over the long haul, bonds pay out a lower return on your investment than stocks. In that case, you might not earn enough to outpace inflation. Investing only in bonds might not enable you to save enough for retirement.
Companies can default on bonds. That's why you need to check the bondholder’s S&P ratings. Bonds and corporations rated BB, and worse are speculative. That means they could quickly default. They must offer a much higher interest rate to attract buyers.
For many people, valuing bonds can be confusing. That's because bond yields move inversely with bond values. In other words, the more demand there is for bonds, the lower the yield. That seems counter-intuitive. Why would investors want bonds if the yields are falling? Because bonds seem safer than stocks.
What Bonds Tell You About the Economy
When the stock market is doing well, investors are less interested in purchasing bonds, so their value drops. Borrowers must promise higher interest payments to attract bond purchasers. That makes them counter-cyclical. When the economy is expanding or at its peak, bonds are left behind in the dust.
The average individual investor should not try to time the market. You should never sell all your bonds, even when the market is at its peak. That's when you should add bonds to your portfolio. That will provide a cushion for the next downturn. A diversified portfolio of bonds, stocks, and hard assets gets you the highest return with the least risk. Hard assets include gold, real estate, and cash.
When the economy contracts, investors will buy bonds and be willing to accept lower yields just to keep their money safe. Those who issue bonds can afford to pay lower interest rates and still sell all the bonds they need. The secondary market will bid up the price of bonds beyond their face values. That means the interest payment is now a lower percentage of the initial price paid. The result? A lower return on the investment, hence a lower yield.
Bonds affect the economy by determining interest rates. Bond investors choose among all the different types of bonds. They compare the risk versus reward offered by interest rates. Lower interest rates on bonds mean lower costs for things you buy on credit. That includes loans for cars, business expansion, or education. Most important, bonds affect mortgage interest rates. Lower mortgage rates mean you can afford a bigger house.
Bonds also affect the stock market. When interest rates rise, stocks look less attractive. They must offer a higher return to compensate for their higher risk.