You probably understand that a balanced investing portfolio includes both stocks and bonds, and that bonds can be less risky than stocks. But what are bonds, exactly? When you buy bonds, you’re providing a loan to the bond issuer, who has agreed to pay you interest and return your money on a specific date in the future.
Stocks tend to get more media coverage than bonds, but the global bond market is actually larger by market capitalization than the equity market. In 2018, the Securities Industry and Financial Markets Association (SIFMA) estimated that global stock markets were valued at $74.7 trillion, while global bond markets were worth $102.8 trillion. Let’s take a deeper dive into bonds to help you better understand this key asset class.
What Are Bonds?
Bonds are investment securities where an investor lends money to a company or a government for a set period of time, in exchange for regular interest payments. Once the bond reaches maturity, the bond issuer returns the investor’s money. Fixed income is a term often used to describe bonds, since your investment earns fixed payments over the life of the bond.
Companies sell bonds to finance ongoing operations, new projects or acquisitions. Governments sell bonds for funding purposes, and also to supplement revenue from taxes. When you invest in a bond, you are a debtholder for the entity that is issuing the bond.
Many types of bonds, especially investment-grade bonds, are lower-risk investments than equities, making them a key component to a well-rounded investment portfolio. Bonds can help hedge the risk of more volatile investments like stocks, and they can provide a steady stream of income during your retirement years while preserving capital.
Key Terms for Understanding Bonds
Before we look at the different types of bonds, and how they are priced and traded in the marketplace, it helps to understand key terms that apply to all bonds:
- Maturity: The date on which the bond issuer returns the money lent to them by bond investors. Bonds have short, medium or long maturities.
- Face value: Also known as par, face value is the amount your bond will be worth at maturity. A bond’s face value is also the basis for calculating interest payments due to bondholders. Most commonly bonds have a par value of $1,000.
- Coupon: The fixed rate of interest that the bond issuer pays its bondholders. Using the $1,000 example, if a bond has a 3% coupon, the bond issuer promises to pay investors $30 per year until the bond’s maturity date (3% of $1,000 par value = $30 per annum).
- Yield: The rate of return on the bond. While coupon is fixed, yield is variable and depends on a bond’s price in the secondary market and other factors. Yield can be expressed as current yield, yield to maturity and yield to call (more on those below).
- Price: Many if not most bonds are traded after they’ve been issued. In the market, bonds have two prices: bid and ask. The bid price is the highest amount a buyer is willing to pay for a bond, while ask price is the lowest price offered by a seller.
- Duration risk: This is a measure of how a bond’s price might change as market interest rates fluctuate. Experts suggest that a bond will decrease 1% in price for every 1% increase in interest rates. The longer a bond’s duration, the higher exposure its price has to changes in interest rates.
- Rating: Rating agencies assign ratings to bonds and bond issuers, based on their creditworthiness. Bond ratings help investors understand the risk of investing in bonds. Investment-grade bonds have ratings of BBB or better.
What Are the Different Types of Bonds?
There are an almost endless variety of bond types. In the U.S., investment-grade bonds can be broadly classified into four types—corporate, government, agency and municipal bonds—depending on the entity that issues them. These four bond types also feature differing tax treatments, which is a key consideration for bond investors.
Corporate bonds are issued by public and private companies to fund day-to-day operations, expand production, fund research or to finance acquisitions. Corporate bonds are subject to federal and state income taxes.
U.S. government bonds are issued by the federal government. They are commonly known as treasuries, because they are issued by the U.S. Treasury Department. Money raised from the sale of treasuries funds every aspect of government activity. They are subject to federal tax but exempt from state and local taxes.
Government service entities (GSEs) like Sallie Mae and Freddie Mac issue agency bonds to provide funding for the federal mortgage, education and agricultural lending programs. These bonds are subject to federal tax, but some are exempt from state and local taxes.
States, cities and counties issue municipal bonds to fund local projects. Interest earned on municipal bonds is tax-free at the federal level and often at the state level as well, making them an attractive investment for high-net-worth investors and those seeking tax-free income during retirement.
We can further classify bonds according to the way they pay interest and certain other features:
- Zero-Coupon Bonds: As their name suggests, zero-coupon bonds do not make periodic interest payments. Instead, investors buy zero-coupon bonds at a discount to their face value and are repaid the full face value at maturity.
- Callable Bonds: These bonds let the issuer pay off the debt—or “call the bond”—before the maturity date. Call provisions are agreed to before the bond is issued.
- Puttable Bonds: Investors have the option to redeem a puttable bond—also known as a put bond—earlier than the maturity date. Put bonds can offer single or several different dates for early redemption.
- Convertible Bonds: These corporate bonds may be converted into shares of the issuing company’s stock prior to maturity.
Investors work with their financial advisor to help select bonds that provide income, tax advantages and features that make the most sense for their financial goals.
How Do Bond Ratings Work?
All bonds carry the risk of default. If a corporate or government bond issuer declares bankruptcy, that means they will likely default on their bond obligations, making it difficult for investors to get their principal back.
Bond credit ratings help you understand the default risk involved with your bond investments. They also suggest the likelihood that the issuer will be able to reliably pay investors the bond’s coupon rate.
Much like credit bureaus assign you a credit score based on your financial history, the credit rating agencies assess the financial health of bond issuers. Standard and Poor’s, Fitch Ratings and Moody’s are the top three credit rating agencies, which assign ratings to individual bonds to indicate and the bank backing the bond issue.
|Investment Grade Ratings
|Speculative Grade Ratings
Generally speaking, the higher a bond’s rating, the lower the coupon needs to be because of lower risk of default by the issuer. The lower a bond’s ratings, the more interest an issuer has to pay investors in order to entice them to make an investment and offset higher risk.
How Are Bonds Priced?
Bonds are priced in the secondary market based on their face value, or par. Bonds that are priced above par—higher than face value—are said to trade at a premium, while bonds that are priced below their face value—below par—trade at a discount. Like any other asset, bond prices depend on supply and demand. But credit ratings and market interest rates play big roles in pricing, too.
Consider credit ratings: As noted above, a highly rated, investment grade bond pays a smaller coupon (a lower fixed interest rate) than a low-rated, below investment grade bond. That smaller coupon means the bond has a lower yield, giving you a lower return on your investment. But if demand for your highly rated bond suddenly craters, then it would start trading at a discount to par in the market. However, its yield would increase, and buyers would earn more over the life of the bond—because the fixed coupon rate represents a larger portion of a lower purchase price.
Changes in market interest rates add to the complexity. As market interest rates rise, bond yields increase as well, depressing bond prices. For example, a company issues bonds with a face value of $1,000 that carry a 5% coupon. But a year later, interest rates rise and the same company issues a new bond with a 5.5% coupon, to keep up with market rates. There would be less demand for the bond with a 5% coupon when the new bond pays 5.5%.
To keep the first bond attractive to investors, using the $1,000 par example, the price of the old 5% bond would trade at a discount, say $900. Investors purchasing the 5% bond would get a discount on the purchase price to make the old bond’s yield comparable to that of the new 5.5% bond.
How to Invest in Bonds
You invest in bonds by buying new issues, purchasing bonds on the secondary market, or by buying bond mutual funds or exchange traded funds (ETFs).
- New bonds: You can buy bonds during their initial bond offering via many online brokerage accounts.
- Secondary market: Your brokerage account may offer the option to purchase bonds on the secondary market.
- Mutual funds: You can buy shares of bond funds. These mutual funds typically purchase a variety of bonds under the umbrella of a particular strategy. These include long-term bond funds or high-yield corporate bonds, among many other strategies. Bond funds charge you management fees that compensate the fund’s portfolio managers.
- Bond ETFs: You can buy and sell shares of ETFs like stocks. Bond ETFs typically have lower fees than bond mutual funds.
When buying new issues and secondary market bonds, investors may have more limited options. Not all brokerages offer the ability to purchase bonds directly. And understanding bond prices can be tricky for novice investors.
Bond mutual funds and ETFs are far easier to access for everyday investors. You can easily review the details of a mutual fund or an ETF’s investment strategy and find ones that fit your investment goals. You’re less likely to run into liquidity issues and can generally buy and sell shares of these vehicles with ease.
Whether you decide to work with a financial professional or self-manage your investments, fixed-income investments should be a core part of your investing strategy. In a well-diversified investment portfolio, bonds can provide both stability and predictable income.