You likely have bonds in your portfolio. But do you understand how they work?

I was aware of bonds early in my investing career but will admit that I didn’t really know that much about them or how they actually worked until I took a basic financial management course as part of my master’s program in finance.  I just knew that they paid out interest, were less volatile, and had lower growth potential than stocks.  I was comfortable with the risk of the stock market and wanted the growth, so I didn’t have much interest in bonds and had very few in my portfolio.  My sense is that I am not alone. I think the average investor, even those that invest in them routinely, don’t really understand how bonds work and how they differ from stocks.  The goal of this article is to give a basic primer on bonds and see if I can fill in any of those gaps for you.

What is a bond?

Let’s start with the very basics—a bond is a loan that an investor gives to a company or a government entity (the issuer) which allows them to fund their various business activities. In exchange, the issuer agrees to pay the bondholder interest on a regular basis (usually every 6 months) for as long as they hold their money (until the bond matures).  When the bond term is over, the issuer promises to pay the bondholder back everything that was loaned to them, plus the bondholder keeps all the interest paid along the way.  The bond comes with a certificate, essentially like an IOU.  These certificates used to be printed on paper, but now they are mostly digital.  Because a bond certificate is a contract, it holds value and can be traded.  We’ll talk more about that part later.

That is the high-level view.  Here are some of the terms of the bond that you should know:

1.       The coupon rate: the interest rate that the issuer agrees to pay you. The coupon rate can either be fixed or can change with time (variable).  The frequency of interest payments may be monthly, quarterly, semiannually, or annually but most pay semiannually.

2.       Par value: the amount that you loaned, or the principal of the bond.  Most corporate and government bonds have a par value of $1000 each. The par value is what you should expect to receive at the end of the bond term.  This is also known as maturity value or face value. 

3.       Maturity date: the specific calendar date when the principal (par value) must be repaid. 

4.       Maturity (or term): the length of time from issuance until the maturity date (e.g., “a 10-year Treasury bond”).

Why do governments and corporations issue bonds?

All businesses and governments need money to function, right?  There are only a few ways for them to get that money.   Ideally, the business generates enough revenue to cover all the expenses, pay out a profit to the owners, and still have some left over to invest back into the company.  The reality is the most businesses cannot survive without outside resources, especially companies very early in their business cycle before they start generating a profit and larger corporations that wish to continue to grow on a faster scale.  So, they either borrow the money and pay interest on it (like, from a bank for example), or, they can give up ownership in their company in exchange for cash (by selling stock).  The first method is called debt-financing.  The second is called equity financing.  Bonds allow individual investors to participate in debt-financing and earn interest, whereas stocks allow investors to create equity (ownership) in companies.

Each method has pros and cons to the company.  The main pro of debt financing is that the company doesn’t forfeit ownership or control to the investors.  The company’s only obligation to banks or bondholders is to pay the interest on schedule and pay back the loan at the end of the term.  The con is that the company is contractually required to meet its debt obligations first (before any profit goes to the owners), and that can often be stressful depending on how much debt they have and how high the interest rates are. 

The pro of equity financing is that the company can get cash without any immediate obligation to pay anything back. In exchange, they are giving up a portion of their company. If the company grows, the stockholders participate in that growth, both in the increased value of the stock and their share of any profits or dividends that are distributed to the owners.  If the company fails and goes bankrupt, the owners are not obligated to pay anything to stockholders.  If that company is sold, shareholders get their portion after all the debts are paid.  Another downside for founders of the company is that giving away too much control by selling stock dilutes both their power to run the company as they envisioned and their personal profits.  They are now beholden to the best interest of the stockholders.

What kinds of bonds are there?

I always assumed that selling stocks was the primary way that companies generated cash and that the stock market was much larger than the bond market. It is actually exactly the opposite.  Globally, the bond market is $135-140 trillion dollars in size, compared to $110-120 trillion dollars in equities.  In the U.S, the numbers are $50-55 trillion for bonds and $45-50 trillion for stocks. The reason that you probably hear way more about the stock market is that most corporate bonds are sold to institutional investors rather than retail investors, like you and me.

Anyway, there are a lot of different kinds of bonds out there to choose from.  Here is a list of some of them:

1. Treasuries: these are bonds purchased from the government. US government bonds have different names depending on their maturity.

   1. T-Bills: short term, (4-, 8-, 13-, 26-, or 52-weeks maturities)

   2. T-notes: intermediate term, (2-,3-,5-,7-, or 10-year maturities)

   3. T-bonds: long term (20-, or 30-year maturities)

      
      

2. TIPS (Treasury Inflation Protected Securities): these are government bonds whose principal value fluctuates with the consumer price index (CPI), offering price protection against inflation. The coupon rate is based on the principal value, so it also fluctuates with inflation. If inflation is high, you are paid more interest.

   
   

3. U.S. Savings Bonds (Series I and Series EE): these are small-denomination, government-backed bonds offered to individual investors directly from the government (not on the secondary market) that earn interest safely, with I Bonds offering inflation protection and EE Bonds offering a long-term doubling guarantee.

   
   

4. Municipal Bonds (Munis): these are issued by state or local governments. To encourage people to invest in their communities, the federal government does not tax the interest income on muni bonds.

   
   

5. Corporate Bonds: these are issued by companies. One of the main risks of investing in bonds is that the issuer goes bankrupt before the bond term is up and is not able to pay back its obligations.  To help investors understand that risk, there are services that rate the various bond-issuing companies according to their risk of default.  Companies are given a letter grade (As, Bs, Cs, and Ds).  The highest grade is AAA.  Then it goes AA, A, BBB, BB, B, CCC, CC, C, D. Sometimes there is a plus or minus after the letter grade and some services use slightly different letters, but you get the point.  This is important because higher rated companies can get lenders to give them money for lower coupon rates, since the risk to the lender is lower.  The further you get down the grading scale, the higher likelihood that the company will default on their loans, and so they must offer a much higher coupon rate to entice lenders to risk their money. 

   
   

6. Investment Grade Bonds: these are bonds from companies with high ratings, BBB- or above.  For the most part, lenders expect that these companies will survive and not default on their loans.

   
   

7. Junk Bonds, or High Yield Bonds: any company rated less than BBB- is considered a high-risk company.  Because of the higher risk, they have to offer higher interest. Yield is just another name for what the company is paying out in interest. So, you might earn more with this type of investment, but with that comes the risk of losing your principal to default.

8. Callable Bonds: I won’t go into this in much detail here, but it basically means that a company can pay you back the principal before the full maturity of the bond. As a bondholder, that means you get your money back sooner, but also lose the interest payments that you were expecting. Why would a company call a bond?  Usually, it is because the interest rate has fallen, and they can issue new bonds at a lower rate which saves them money. Having the option to call the bond is an advantage to the company and therefore usually come with higher yields to compensate the bondholder for taking on the risk of the bond being called early.   

   
   

9. Convertible Bonds: these are bonds that the investor can convert the principal to stocks at some point in the future if the company is doing well. Since this option is an advantage to the bondholder, convertible bonds typically come with lower coupon rates.

   
   

10. Zero-coupon bonds: these bonds don’t pay interest but are sold at a discount from their par value instead.  That is how the bondholder makes money. For example, they purchase a $1000 bond for $950 and make $50 when the bond matures.  Most T-Bills are sold this way.  Zero-coupon bonds may be used for long-term investments, like college funding for example, if you don’t need the immediate income from the interest.

    
    

How are bonds bought and sold?  Primary vs secondary bond markets

To recap, if you buy a bond, you become a lender to the issuer and you are given a contract that says how much you are lending (usually $1000/bond), how much and how frequently they are paying you interest, and when you will get your money back if you hold it until maturity.  The reality is that very few individual investors buy bonds this way, even though most have them in their portfolio.  Most corporations issue bonds only to institutional investors and do so in large quantities.  They usually aren’t even available to the little guy investors like you or me. You can purchase government bonds directly at TreasuryDirect.gov, but it is a little intimidating to figure out how it all works and what the terms of the bonds are.  

The good news is that you don’t have to buy bonds that way. Most of us buy bonds on what is known as the secondary market.  I mentioned above that bonds are contracts and contracts have an inherent value. Anything with value can be bought and sold in a marketplace.  Bonds are the same.  Once they are issued and purchased on the primary market, the primary bondholders can then sell the bond to any interested buyer in the secondary marketplace. 

Stocks actually work the same way. Companies sell the stocks in an initial public offering (IPO) to a group of buyers but then they are subsequently bought and sold in the secondary stock market like the New York Stock Exchange or the NASDAQ.  In any market, prices will fluctuate according to economics and the competing interests of the buyers and sellers. 

When you add bonds to your portfolio, someone (a broker) is buying them for you in this marketplace, usually as part of a mutual fund or ETF. You don’t hold the certificates. You just own a piece of the fund that holds those bonds.  The advantage of this is that unlike when you hold the actual certificates, it is easy to get in and out.  You can buy bonds just like you buy stocks.  The disadvantage is that, unlike when you hold the certificate and know exactly how much you paid and what you will get back at the end of the term, bond values on the secondary market fluctuate. 

More to come

I’m going to go into bond pricing in my next article.   I will also talk about the pros and cons of having bonds in your portfolio and some of the reasons you would choose bonds over stocks or vice versa. So, stay tuned.

If you would like more information about basic financial principles like stocks and bonds and how to invest in them, check out my book, The Physician’s Path to True Wealth. A paperback copy is available on Amazon but you can get a free digital copy by subscribing to my website.  Here is the link.

Disclaimer: the material in this blog post is intended for general educational purposes only and should not be considered specific financial advice. You should always consult with your personal financial advisor to see how it might fit within your personalized financial plan.