What Bonds Are, How They Work, & What They Say About the Economy

Image shows two panels. Title reads: "Advantages and disadvantages of bonds." The first panel reads: "Advantages: receive income through the interest payments. Hold the bond to maturity and get all your principle back. You can profit if you resell the bond at a higher price." The other column says: "Disadvantages: Bonds pay out lower returns than stocks. Companies can default on your bonds. Bond yields can fall"

Image by Mary McLain © The Balance 2019

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.

Types of Bonds

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 are issued by cities and localities. They return a little more than Treasuries but are a bit riskier.

Corporate bonds are issued by companies. They have more risk than government bonds because corporations can't raise taxes to pay for the bonds. The risk and return depend on how credit-worthy the company is. 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 who 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. They can only do this 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.

Example

Imagine The Coca-Cola Company wanted to borrow $10 billion from investors to acquire a large tea company in Asia. It believes the market will allow it to set the coupon rate at 2.5% for its desired maturity date, which is 10 years in the future. It issues each bond at a par value of $1,000 and promises to pay pro-rata interest semi-annually. Through an investment bank, it approaches investors who invest in the bonds. In this case, Coke needs to sell 10 million bonds at $1,000 each to raise its desired $10 billion before paying the fees it would incur.

Each $1,000 bond is going to receive $25.00 per year in interest. Since the interest payment is semi-annual, it is going to arrive at $12.50 every six months. If all goes well, at the end of 10 years, the original $1,000 will be returned on the maturity date and the bond will cease to exist. 

Advantages of Bonds

Bonds pay off in two ways.

Income

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. 

Profit on Resale

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.

Some bonds, known as zero-coupon bonds, do not distribute interest income in the form of checks or direct deposit but, instead, are issued at a specifically calculated discount. These are meant to par and mature at their face value with the interest effectively being imputed during the holding period and paid out all at once when maturity arrives.

Disadvantages

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. They could quickly default. They must offer a much higher interest rate to attract buyers.

Types of Bond Risk

Although generally considered "safe," bonds do have some risk.

Credit Risk

Credit risk refers to the probability of not receiving your promised principal or interest at the contractually guaranteed time due to the issuer's inability or unwillingness to distribute it to you. Credit risk is frequently managed by sorting bonds into two broad groups—investment-grade bonds and junk bonds. The absolute highest investment-grade bond is a Triple-A rated bond.

Inflation Risk

There is always a chance that the government will enact policies, intentionally or unintentionally, that lead to widespread inflation. Unless you own a variable rate bond or the bond itself has some sort of built-in protection, a high rate of inflation can destroy your purchasing power. By the time you receive your principal back, you may find yourself living in a world where prices for basic goods and services are far higher than you anticipated.

Reinvestment Risk

When you invest in a bond, you know that it's probably going to be sending you interest income regularly. There is a danger in this, though, in that you cannot predict ahead of time the precise rate at which you will be able to reinvest the money. If interest rates have dropped considerably, you'll have to put your fresh interest income to work in bonds yielding lower returns than you had been enjoying.

Liquidity Risk

Bonds can be far less liquid than most major blue-chip stocks. This means that once you acquire them, you may have a difficult time selling bonds at top dollar. This is one of the reasons it is almost always best to restrict the purchase of individual bonds for your portfolio to bonds you intend to hold until maturity. 

Yield Versus Price

For many people, valuing bonds can be confusing. They don't understand why 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.

The reason lies in the secondary market. As people demand bonds, they pay a higher price for them. But the interest payment to the bondholder is fixed; it was set when the bond was first sold. Buyers on the secondary market receive the same amount of interest, even though they paid more for the bond. Put another way, the price they paid for the bond yields a lower return.

Investors usually demand bonds when the stock market becomes riskier. They are willing to pay more to avoid the higher risk of a plummeting stock market.

What Bonds Say About the Economy

Since bonds return a fixed interest payment, they look attractive when the economy and stock market decline. When the business cycle is contracting or in a recession, bonds are more attractive.

Bonds and the Stock Market

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.

When bond yields fall, that tells you the economy is slowing. 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. 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 and Interest Rates

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.

Key Takeaways

When you invest in bonds, you lend your money to an organization that needs capital. The bond issuer is the borrower/debtor. You, as the bond holder, are the creditor. When the bond matures, the issuer pays the holder back the original amount borrowed, called the principal. The issuer also pays regular fixed interest payments made under an agreed-upon time period. That's the creditor's profit.

Bonds as investments are:

  • Less risky than stocks. So, these offer less return (yield) on investment. Make sure these are backed by good S&P credit ratings.
  • Allowed to be traded for a higher price.

The best time to take out a loan is when bond rates are low, since bond and loan rates go up and down together.

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