A bond, simply put, is a loan from an investor to a borrower. The borrower is typically a corporation or government entity and are typically used to finance projects and operations. Instead of the corporation going to a bank, they instead receive money from an investor who purchases the bond.
In exchange for providing capital, the company or government entity pays interest at a predetermined interval (typically annually or semiannually). Upon the maturity date, the company then returns the principal, therefore ending the loan.
How Does a Bond Work?
When the entity needs to raise money for any variety of reasons, from financing projects, refinancing existing debts, to just maintaining operations, they can issue bonds directly to investors. The company/entity is the borrower/issuer of the bond and will include the pertinent details of the loan including terms, interest payments, and the maturity date.
The present value of a bond determines the current market price of the bond. To calculate the present value of a bond, you will need the following information:
- The bond amount
- The maturity date of the bond
- The interest rate at the end of each year.
With this information, you can calculate the present value of your bond in five steps.
In this example, we will examine a scenario where your bond amount is $50,000, with a five-year maturity date, and an interest rate of 6% at the end of each year.
First, you will determine the interest being paid on the bond annually. In this example, the amount is calculated by $50,000 bond amount by the 6% interest rate, equaling $3,000.
Next, consult the financial media to find the market interest rate for similar bonds. You will look for bonds with the same maturity date, stated interest rate, and credit rating. For this example, the market interest rate is 8% because similar bonds are priced to return that amount. The stated interest rate in our sample above is only 6%, the bond has been priced at a discount so the investor can still achieve the 8% market rate.
You will then go to a present value of $1 table. Locate the present value of your bond’s face value. In our example, the present value factor for our bond payable in 5 years at 6% interest is 0.7473. To determine the face value, you will calculate the $50,000 bond amount by the 0.7473 present value factor, which equals $37,365.
After you complete step 3, you will next go to a present value of an ordinary annuity table to find the present value of the stream of interest payments. Use the 8% market rate. In our example, we will find that the amount is 3.9927. To calculate this figure, you will multiple your $3,000 interest payments by the 3.9927 present value factor, making your interest present value $11,978.
Finally, to determine the present value of your bond, you will add your bond present value plus the interest present value. $37,365 + $11,978 = 49,343.
The maturity date of your bond is the date in which you, the investor, can expect to have the principal of your loan repaid. Bonds can have a varying length when determining maturity. Short term bonds last one to five years.
A bond that is five to twelve years is known as an intermediate term bond. Finally, there are long term bonds that last twelve years to thirty years. Typically, the longer the maturity date, the higher the interest rate on the bond will be.
The face value of your bond is equal to the price of the bond when it was first issued. After that, your bond will fluctuate according to the market with interest changes. The face value will always remain fixed. Face value can also be called the par value. As the price of your bond fluctuates, it is commonly described as trading above or below par value.
In simple terms, the coupon rate of your bond is the interest rate paid by its issuer. In the above example, the coupon rate is 6%. To determine the amount of that coupon rate percentage we calculated the $50,000 bond amount by the rate of interest annually, totaling $3,000.
This amount is set when the bond is issued. As an investor, you can expect to receive a $3,000 coupon payment each year until the bond matures since the 6% coupon rate is fixed.
The date in which you receive your coupon payment is called the coupon date. As a bondholder, you are guaranteed to receive that coupon rate on a fixed date either annually or semiannually, depending upon the terms of your bond investment.
Let’s look at another example of how a bond works. In this example, Company X needs funding for a new project. They issue a bond that can be purchased by an investor. The company’s bond has a face value of $10,000 and a coupon rate of 5%. The investor will be loaning the company money for 10-years.
If the investor agrees to purchase the bond, both parties agree to:
- Provide Company X with a $10,000 loan
- The interest paid to the investor will be $500 annually for a 10-year period
- The company will repay the $10,000 to the investor at the end of the 10 years
However, if the investor wants to sell their bond before it matures, there are options for that as well.
Types of Bonds
There are several types of bonds available for investors. Let’s review the different kinds below.
Government bonds, also known as U.S. Treasury bonds, are issued by the U.S. Department of the Treasury at the bequest of the federal government. Because they carry the credit of the U.S. government, they are one of the most popular and safe investments. Most government bonds are long-term securities that mature in 30 years and pay interest semiannually.
Municipal bonds are also issued by government entities, but they are issued by states, cities, and counties. These bonds fund the day-to-day obligations of the municipality, or finance capital projects like highways and building schools. This type of bond can be short-term and mature within three years, or a long-term bond that won’t mature for a decade or longer.
Interest on municipal bonds is typically exempt from federal income tax. It might also be exempt from local and state taxes depending upon the state where the municipal bond is issued. There are three types of municipal bonds.
General Obligation Bonds
General obligation bonds are backed only by the “full faith and credit” of the issuer. They have the power to tax residents to pay the bondholder. With general obligation bonds, the municipality does not use any assets as collateral and will repay the debt through revenue or taxation from the project(s).
Revenue bonds are backed by revenues from specific sources or projects, like lease fees or highway tolls. The specific project, whether it is a local highway, airport, or sports stadium, produces revenue. Differing from general obligation bonds, revenue bonds are repaid through various tax sources. These bonds are project-specific and not funded by the taxpayers.
Conduit bonds are a type of municipal bonds that are issued on behalf of private entities like non-profit hospitals and colleges. These tax-exempt municipal bonds fund projects that are larger in scale and benefit the public.
When a conduit municipal bond is issued, the private entity (borrower) receives the funding from the municipality. They are then responsible for the principal and interest payments to the bondholder. The bond debt is secured through the revenue from the project
Corporate bonds are issued by public and private corporations. Instead of these companies seeking loans from banks, they tend to favor bonds because of more favorable terms and lower interest rates. While corporate bonds are still considered a safe investment, they are higher risk than government bonds, even for companies that have superior credit quality.
You might be wondering the key differences between corporate bonds and stocks. If you buy a corporate bond, you are lending money to that corporation. However, if you purchase stocks you are buying an ownership share in the company.
With bonds, you are not at risk of a value decrease if the stock price falls. Instead, you are paid interest based on your original investment — and in the event that the company goes under, it must pay bondholders and other creditors before stock owners, who might not ever be fully reimbursed.
An investment-grade bond is a classification denoting a bond that carries a relatively low credit risk — in comparison to other bonds. The three major credit rating agencies (Fitch, Moody’s, and Standard & Poor’s) rate each bond. A classification of BBB- or higher is investment grade for Standard & Poor and Fitch. A classification of Baa3 or higher is investment grade for Moody’s.
Investment-grade bonds range from the lowest credit risk to a moderate credit risk, but they generally meet payment obligations. If a bond is not investment-grade, they are typically called high-yield bonds, junk bonds, or non-investment-grade bonds.
U.S. Treasury bonds are a safe investment. They are backed by the full faith and credit of the United States government. However, because they are considered to be a low risk investment, they typically offer lower yields than other bond options. There are three types of Treasuries that you can purchase.
Treasury bills typically mature in less than a year. They are sold with variable maturities, the most common of terms are four, eight, 13, 26, and 52 weeks. The interest on US Treasury bills is paid with the principal at maturity.
TIPS (Treasury Inflation-Protected Securities)
Treasury Inflation-Protected Securities (TIPS) are designed to help investors be protected against inflation. The maturity for TIPS can be 5-years, 10-years, or 30-years.
This type of treasury bond is adjusted to pay investors a fixed interest rate at the bond’s par value and adjusted with the inflation rate. The interest on TIPS is paid yearly. However, it’s important to note that TIPS differ from other Treasuries because the principal value adjusts based on inflation as well.
Treasury notes are an intermediate-term bond that matures within two to ten years. Like TIPS, Treasury note interest is paid semi-annually. The principal is paid upon maturity.
What Are the Benefits Associated With Bonds?
As mentioned above, one of the key differences between bonds and stocks is that bonds invest in debt, where stocks invest in equity. Investing in a company’s debt is a safer bet than investing in their equity. But that’s not the only reason you should consider bonds as part of your investment strategy.
Reliable Stream of Income
When you invest your money, your goal is likely to improve your financial wealth. Bonds are a great way to generate a reliable return as an investor. They provide a consistent stream of income with their trusted interest payments.
Preservation of Capital
A conservative investment strategy where the goal is to preserve your capital to prevent a loss is one of the key benefits associated with bonds. If you are looking for a safe, reliable way to protect your capital, a bond is a great option. In fact, many people as they near retirement choose to invest in short-term bonds to keep their capital protected from the volatility of the stock market.
Less Volatile Than Stocks
Stocks are a higher risk investment than bonds. While the risk comes with rewards, like generally a higher payout, bonds are not susceptible to market fluctuations.
What Are the Risks Associated With Bonds?
Although bonds will generate consistent income and preserve your capital, that does not mean they do not come without risk. Before you invest in bonds, you should take a look at the risks associated with them to make an educated investment decision.
When you commit to a bond, you are agreeing to the rate of return for the lifetime of the bond, as long as you hold it. But when inflation and cost of living increases, investors purchasing power diminishes, causing them to lose money on the investment. An investor faces a higher risk of inflation the longer the term of the bond.
Bonds can be a liquidity risk. This refers to an investors ability to sell quickly at a reasonable price. A bond might sell at a price lower than expected based on market conditions.
When you purchase a bond, you are, in the simplest terms, providing a company or government entity with a line of credit. The company then must pay you back your capital with interest over time. However, if you are purchasing a corporate bond, be aware that they are not guaranteed by the full faith and credit of the U.S. Government. Instead, it all depends on the company’s ability to repay their debt.
Before you blindly invest in bonds, be aware that there is the possibility that the company can default. Be sure to do your research on the company.
Interest Rate Risk
There is an opposite relationship between bond prices and interest rates. When interest rates dip, bond prices increase. And when interest rates rise, bond prices typical fall.
The reason for this is because when interest rates begin to decline, many investors will try to capture the highest rates that they can. They do this by scooping up current bonds that have a higher interest rate than the current prevailing market rate. This causes an increase in demand, which in turn causes an increase in bond prices.
Certain bonds, some corporate and municipal, can be called before their maturity date by their issuer. If you purchase a callable bond, you are purchasing bond with the potential risk to end early. This can result in your projected investment earning less than expected.
As an investor, you will then have your capital back, yet might not have the option to reinvest it at a comparable rate as what you had planned with your original investment.
With some bonds, you risk prepayment. When the issuer returns part of your principal early, they no longer are required to make interest payments on that portion of the principal. You will then see a decrease in interest payments, which could impact your projected income.
How To Invest in Bonds
If you are interested in investing in bonds, you will need to utilize a broker. Unlike stocks, most bonds are not traded publicly. However, treasury bonds are the exception as you can buy them directly from the U.S. government without a middleman.
As an investor, it can be difficult to know if you are paying a fair price for a bond since they are not traded on a centralized market. While a broker might sell a bond at a premium to gain a profit, another broker might have an even higher premium. Thankfully, the Financial Industry Regulatory Authority (FINRA) does regulate the bond market by posting transaction prices. However, the data might lag because they are only able to price the data as it becomes available.
Stocks vs Bonds
As mentioned above, a bond is a loan that you are giving a company or government entity. A stock, on the other hand, provides you with partial ownership, or equity, in a corporation. The biggest difference between the two is how they generate profit for the investor.
With bonds, the borrower must pay back the investor with a fixed interest rate over time. With stocks, the value of the share must appreciate in time to be sold later at a higher value. While both are valuable ways to invest, the way they are structured and provide a return vary greatly.
What’s Next: Hiring A Financial Advisor Or DIY Financial Planning
If you’re ready to begin investing in bonds, it is worth considering hiring a financial advisor. They provide a variety of services to help people with their personal money and wealth management. Financial advisors can provide recommendations for specific investments, or just draw up plans to help get you on your way.
Alternatively, if you’re looking to go the DIY financial planning route, be prepared to track and report your finances to stay organized. Start by mapping your current financial state by listing your current assets and liabilities. Then, you can make plans for your financial future.
There are many tools that can help guide you, including software from Quicken, WealthTrace, MoneyGuidePro, and a handful of others. Be fully committed to organizing your plan and set aside time each week to review your plan and financial status.
As always, if you become overwhelmed by all the options available for DIY financial planning, turn to a financial advisor to help assist you.