Welcome back to Personal Finance for Professionals Part II, our multi-lesson series teaching you everything you ever wanted to know about investing in stocks and bonds. Last time we concluded the Stocks portion by discussing market timing and its antithesis, dollar-cost averaging. Today we move on to Bonds, the bowtie-wearing, MUZAK-listening, less hip older brother to Stocks.
Introduction to Bonds
What is a Bond?
A Bond is a fixed-income investment issued by governments (local, state, or federal), corporations, and financial institutions. A bond is essentially a loan: the issuer borrows money from an investor and pays it back over time with simple interest and fixed repayment terms.
Why Would a Company Issue Bonds?
As we discussed in the first lesson of this series, when a business needs to raise money, there are only a few ways to do it. Issuing stock raises cash but dilutes current owners, while retaining earnings takes time and uses up company profits.
A company may also raise money by taking on debt. This debt can be borrowed from a bank or by issuing bonds, where the money comes from investors and often has better terms than from a financial institution.
Companies and governments issue bonds for the same reasons that anyone borrows money. Either they don’t have enough cash right now to buy what they want, or they feel they have a better use for their cash and prefer to borrow money to buy what they want right now. For governments, bonds usually fund infrastructure projects; a city doesn’t want to wait 20 years to save money to build a new road, so it borrows money to do it now and pays it back with tolls on the new roadway. Companies typically issue bonds to fund growth projects or acquisitions, or to shore up their finances when interest rates are low.
The Initial Sale of a Bond
The initial sale of a bond is easy to understand. Like any loan, an amount is borrowed under specific repayment conditions. The lender (bondholder or investor) lends a certain amount of money (bond value), expecting repayment with interest over time. The borrower (bond issuer) must repay this money under the specified conditions (time, interest rate).
A bond is typically issued through an investment bank. Company A needs to raise $100,000,000 to expand its AI infrastructure, so they engage an investment bank to take its bond to market. Bond investors include other companies, banks, pension funds, bond funds, and private investors.
As with all loans, bond issuers want to pay the lowest interest rates possible, while the bondholders (the investors) want to receive the highest interest rate they can get. Several factors influence interest rates on bonds:
- The credit rating of the issuer – This is like your personal credit score. The higher your score, the better the chance you will pay back your loan, and the lower the rates you pay. Companies and governments also have a credit rating, based on their perceived financial strength and stability. Different rating agencies rate companies and their bonds, typically using an alphabetic system. AAA bonds have the highest rating and are given only to the most financially strong and secure companies and governments. BBB ratings reflect lower perceived creditworthiness and pay a higher rate. Higher ratings are considered “investment grade bonds,” while lower ratings are considered non-investment-grade, or “junk bonds.”
- The prevailing interest rate – When general interest rates are higher, bond rates will go up, and vice versa.
- Supply/Demand – Like any commodity or product, bond rates are influenced by how many people want to buy them. The less desirable fixed-income investments are at any given moment, the higher the bond rate must be for investors to purchase them. Macroeconomic factors, such as the strength of the economy and expected inflation, influence investor appetite for bonds. The higher the expected inflation, the higher the rate a bond investor will demand to compensate.
- Length to Maturity – The longer the bond, the higher the rate must be to compensate the investor for the additional risk.
Types of Bonds
Most bonds are fixed-rate bonds, including most corporate bonds and US Treasuries. The issuer periodically pays a fixed interest rate to the bondholder and returns the principal at the maturity date (end of the term). For example, a company issues a $1M bond for 10 years at 10% simple interest paid annually. The bondholder buys the bond for $1M, and the company pays the holder $100,000 each year for 10 years. At maturity, the company pays back the original $1M.
Other bond types exist, including “zeros,” which have no periodic interest payments; the most common being US Treasury Bills. A bill is simply a bond with a term of one year or less. The issuer of a zero borrows less money than they will pay back at the maturity date. Another way to phrase this is that the initial price is less than the par value. For example, the US government issues a $1M, 1-year Treasury Bill at a 5% interest rate. The bondholder buys the bill for $952,381, and in one year the government pays back $1,000,000.
Bond Terminology
- Par Value – The bond value paid at maturity. Also known as the face value. Also, the amount of money on which the issuer pays interest.
- Coupon Rate – The interest rate, expressed as a percentage.
- Maturity Date – The date the bond matures and the issuer must pay the par value.
- Issue Price – The initial price of the bond, usually the same as the par value.
Secondary Market for Bonds
Like stocks, bonds can be bought and sold on the secondary market after the company’s initial offering. Once a bond has been issued and sold, the issuing company has no control over who owns the bond and must pay according to the initial conditions. This is like taking a mortgage with your local bank and then having it sold to another company. The terms of the original loan still hold. You still must pay the same amount, just to someone else.
While the issuer must abide by the bond’s original conditions, the bond can be bought or sold at a variable market price. Because bond payments are based on a fixed interest rate, secondary bond prices tend to fall when interest rates rise and rise when interest rates fall. This is best understood by an example.
—————————————————-
Company A issues a $100,000, 25-year bond with a 5% interest rate paid annually in 2026. John purchases the bond and receives $5,000 per year until 2030. At that time, interest rates have dropped to 2.5%, and Company A is issuing a new 20-year bond. John now wants to sell his 2026 bond with 20 years left to maturity on the secondary market. What is the value of John’s bond?
Is John’s 2026 bond worth more or less than Company A’s 2030 issue? If they were equally priced, why would anyone choose to buy a bond for $100,000 and receive $2,500 in annual interest for twenty years when they could spend $100,000 and receive $5,000 per year for the same period? They wouldn’t, and John wouldn’t sell for that price either. His bond is now more valuable because it pays a higher return than the new bond.
John’s bond increases in value until the interest rate it receives matches the current rate. A $100,000 bond paying 2.5% brings in $2,500 per year. John’s bond pays $5,000 per year, so divide by 2.5% to get the new value: $200,000. Since the interest rate has halved, the value of John’s bond has doubled.
If the interest rate had risen to 10% instead, John’s bond would be worth only $50,000. The price of an existing bond is inversely related to the prevailing interest rates.
—————————————————-
If you hold a bond until maturity, you will receive the annual coupon (interest payment) and the par value (your money back). If you sell a bond before the maturity date, the price will be calculated based on current interest rates and the number of years remaining until maturity.
How to Purchase a Bond
Investors can purchase individual bonds or bond funds. While an individual investor can technically purchase corporate bonds during their initial sale, access is often limited, and the minimum purchase amounts are often prohibitively high. Most investors therefore purchase corporate bonds on the secondary market.
Government bonds can often be purchased directly from the issuer. You can buy US Treasuries at https://www.treasurydirect.gov/. You can purchase bonds inside retirement accounts and brokerage accounts.
Bond Risk
Bonds, as fixed-interest investments, are generally considered safer than stocks and are used to reduce the risk of an all-stock portfolio. We will discuss this in the next lesson. However, bond investing does come with three specific risks.
- Default Risk – This is the risk that a bond issuer does not make payments as promised. Bondholders receive higher priority in bankruptcy proceedings than stockholders but can still lose money. This risk is small for highly rated investment bonds, but it is not zero. Even large, well-respected companies have gone bankrupt in the past. Junk bonds pay higher interest rates, but default is common. Even municipalities can occasionally default. However, the US government has never defaulted on US Treasuries.
- Interest Rate Risk – We have already discussed how a bond’s price on the secondary market is inversely related to prevailing interest rates. If you hold a bond to maturity, you will receive the promised interest payments and the returned principal. But if interest rates rise, you won’t be able to sell your bond for what you paid for it.
- Inflation Risk – Inflation erodes a currency’s purchasing power. If you purchase a 4% 30-year bond, the money used to buy the bond is worth more today than it will be at maturity due to inflation. Think of it like this. If I borrowed $1.50 from you ten years ago, that was enough to buy a dozen eggs at the time. Now I’m due to pay you back, but that same $1.50 will only buy six eggs. Additionally, each interest payment you receive from the bond will be worth less each year. In fact, if inflation is higher than the coupon rate, you will have a negative real (inflation-adjusted) return.
To reduce risk, it is better to buy bond funds than individual bonds. Bond funds combine multiple bonds into a single security, allowing you to diversify your portfolio without having to choose and purchase the bonds yourself. This diversity protects you from default risk but does not protect you from other bond risks.
Bond funds are similar to stock funds and come in multiple varieties, such as mutual funds and index funds. Bond funds can be both actively and passively managed. VTBLX is Vanguard’s Total Bond Market Index Fund, where you can buy a small piece of every publicly traded bond in the US.
Tax Treatment of Bonds
Bonds are taxed differently depending on the issuer, but interest collected on the bonds is typically taxed as ordinary income unless otherwise specified. If you sell a bond for more than you paid, the difference is taxed at the capital gains rate. Here is a breakdown.
- US Treasury Bonds – Federal Tax: Taxable. State and Local Tax: Exempt.
- Municipal Bonds – Federal Tax: Generally exempt. State and Local Tax: Exempt if issued by your home state or municipality.
- Corporate Bonds – Federal Tax: Taxable. State and Local Tax: Taxable.
Because of this tax treatment, bonds are more appropriately held inside pre-tax retirement accounts, where you will not be taxed each year on interest payments.
Conclusion
Bonds are fixed-income investments typically purchased by investors on the secondary market, often through index funds. Bonds represent a loan to a company or government agency, on which interest will be paid back for a predetermined period, at which time the principal will be returned. Bond prices fluctuate in the secondary market based on current interest rates and other macroeconomic factors.
In the next lesson in this series, we will examine why investors buy bonds, how stocks and bonds are related, and the role bonds play in your portfolio.
Thanks for reading. If you have any questions, concerns, or comments, leave them below. Also, consider subscribing so you don’t miss any blog posts or updates from Business is the Best Medicine.