Bonds have long been considered great investments for retirement, newborn gifts, children's birthday gifts, college savings, and more due to their increased dependability compared to stocks, which helps preserve the principal.
However, since bond investing is not as common as stock investing, it can be a bit confusing to the common investor, even though bonds are regarded as a simpler way to invest.
Hence, this brief explanation will help make investing in bonds easier to understand, no matter your investment background.
Definition of a Bond
A bond is a certificate purchased by an investor with the promise of the issuer to repay the principal of the bond in full at the maturity date.
So, essentially, it is a loan to the bond issuer, which makes the purchaser a creditor who stands to capitalize off their borrowed funds.
A bond can be purchased by anyone starting at a price of just $25 up to $10,000 per year, depending on the bond type.
How Bonds Work as Investment Vehicles
When you purchase a bond, you are paying for the interest paid on the original amount you paid for the certificate, which enables you to receive more in return than what you initially invested.
Hence, it is like investing in stock; however, instead of buying shares of ownership in the company, you are purchasing sum interest payments on the principal of your loan for a greater return on your investment.
Details of a Bond
The repayments of the bond are based on its details/characteristics, which are as follows:
The face value is the full amount the bond will be worth when it expires. It is also the amount that will be used to determine your interest payments.
The maturity date states when the bond will expire, and the face value of the bond is to be repaid by the issuer.
Typically a bond's maturity date ranges between one and thirty years, depending on its type, during which time you can cash it in whenever you'd like. However, to receive the full principal plus all interest payments, you must hold the bond until the maturity date.
The coupon rate is the percentage of interest the issuer of the bond will pay on the face value of the certificate, which is ultimately determined by its maturity date and quality.
In general, the longer the bond's maturity date the higher the interest rate paid.
Bonds issued by entities with poor credit ratings, also known as junk bonds, also pay the higher interest due to the increased risk of the bond's default, which helps justify the investment.
On the other hand, bonds issued by entities with a higher credit rating are considered quality bonds because the issuers are more stable. However, they typically only pay average interest rates.
A bond's coupon rate can be fixed, meaning it pays equal interest payment amounts over the life of the loan, or variable, which means it is determined by a prime rate or an interest rate index.
The coupon date states when your interest payments will begin, which the issuer usually pays semiannually.
Factors That Determine the Price You Initially Pay for a Bond
Generally, when you purchase a bond, it is available at a price lower than its face value. However whether or not this is the case depends on various factors, including:
Yield to Maturity
A bondholder can hold onto the certificate until maturity, or they can sell it in the open market, where the price other investors pay for it can vary, depending on how close the bond is to maturity.
Typically, the farther away from maturity the bond is, the lower its price and vice versa.
Market Interest Rates
Bond prices also tend to move opposite to market interest rates.
In short, this means that when interest rates are low, they trade at a premium; however, when interest rates are high, they can be bought at a discount.
Types of Bond Issuers
Bonds are generally sold as a way for organizations to raise money from investors while also providing them with guaranteed repayment of their principal in addition to a stream of interest payments.
The two major issuers of bonds are:
The most common type of bond issuer is the government, which is available as a T-bond, T-note, or T-bill.
These bonds are issued by the federal government to help fund the building of new roads, schools, sewer systems, highways, and other infrastructures that lend to the well-being of a region.
However, the government may also offer them to fund war costs during emergencies.
Government bonds are considered the safest since they are backed by the U.S Treasury; however, they also typically pay lower interest rates. They also come with tax benefits.
Government Bond Varieties
U.S. Savings Bonds
U.S. savings bonds are available in Series EE and Series I types, which both have a maturity of 30 years; however, Series I bonds pay interest based on an inflation index.
Both are also sold at face value, but paper EE bonds can be purchased at half their face value.
Municipal bonds are issued by state and local governments; however, they typically require a minimum investment of $5,000 compared to a minimum of between $50 and $100 with other government bonds.
They are also vulnerable to local government economic activity, so they are not considered as safe as federal bonds.
Companies may also issue bonds to fund their operations or to grow their business.
Corporation Bond Varieties
A callable bond enables a company to call it back before the maturity date, which generally occurs when their credit rating improves or interest rates go down because it enables them to reissue the bonds at a lower rate.
A puttable bond includes a put option that enables the holder to resale the bond to the company when they speculate interest rates will increase, thus causing the bond to decrease in value. This way, they get their original investment back before it does.
Convertible bonds allow investors to convert their debt certificates into shares of stock when their price increases above a certain amount.
This way, the company benefits from the initial sales of the bonds to fund their project, and the bondholders get the advantage of owning stock in it if all goes well.
Zero Coupon Bond
Zero coupon bonds are sold at a fraction of the price of their face value in exchange for no interest payments. Hence, the investor's return is simply the bond's par value when it expires.
So to reiterate, bonds offer a more secure way to invest in securities but with lower interest rates, which makes them more suitable as part of an investment portfolio for their stability.
In the meantime, to get the most out of your bond, be sure to hold it until maturity, after which time it is easy to cash in online or by visiting your bank to receive the principal plus all interest payments.
However, if your bonds were purchased as part of an investment portfolio, your manager will handle all transactions for you.