Understanding all sides of this fixed-income investment.
Without loans, most of us wouldn’t be able to afford big-ticket purchases like a car, a home, or an education. Similarly, governments and businesses sometimes need loans to fund new projects or pay for operating costs.
However, while we can go to a bank and apply for a mortgage, it isn’t that simple for a corporation or the government. These entities usually need more money than a bank can offer them. So, in order to raise the necessary funds, corporations and governments will issue bonds to investors – yes, you can lend the government money.
There are many different types of bonds, so it can be a challenge to figure out their risk levels and earning potential — and the jargon used to describe them can sound like another language sometimes.
Not to worry, Flahmingo is here to help. In this blog, we’ll cover what a bond is, how they can make you money, and how to assess their risk level. Let’s get into it!
So, what is it?
A bond is basically a formalized I.O.U. — it’s a loan given to a company or government (called the bond issuer) by the investor who purchases the bond (called the bondholder).
Bonds are issued by companies and governments to pay for expenses. Sometimes, the expense is so large that the company or government needs to borrow money from more than one source, meaning an individual bond is just one piece of a massive loan.
Once the bond is purchased, the bond issuer agrees to pay interest to the bondholder at regular intervals until the bond matures, as well as a fixed amount known as the face value or par value on the bond’s maturity date.
Fun fact! A bond’s face value can be different from the price an investor pays for the bond, especially if the investor purchases the bond on a secondary market (a.k.a. from another investor instead of the issuer). When you buy a bond directly from an issuer, its price is usually set at par – the amount the issuer has agreed they owe you. However, a bond’s price on the secondary market can go up and down depending on economic conditions, just like any other investment.
The amount of interest a bond pays (called the coupon), how often it’s paid (usually semiannually), how long it’s paid for (called the bond’s term or maturity) and its face value (often set at $1,000) vary from bond to bond. These characteristics don’t change over the bond’s lifetime, which is why we categorize bonds as a fixed-income security. Once you invest in a bond, you generally know what you’re going to get – if you hold onto it until maturity, that is.
There are also zero coupon bonds that are sold at deep discounts to their face value. As the name suggests, they don't pay regular interest payments but you do receive the full face value once it matures, resulting in a profit.
Many bonds (depending on the type) are lower-risk investments than stocks and other equity investments because they carry the promise of paying you back, which makes them a useful tool in an investment portfolio.
Holding bonds has two major benefits: they give you a stream of income and they offset the volatility of stocks and other investments in your portfolio.
Understanding bond terminology
We’ve just thrown around a bunch of terms. Here’s a breakdown of some basic bond vocabulary that will make your life easier:
- Face value/par value: The amount paid to a bondholder at maturity. It’s also used to calculate interest payments. Bonds commonly have a face value of $1,000.
- Coupon rate: The interest rate a bond issuer pays on the face value. For example, a 3% coupon rate means that bondholders will receive 3% x $1,000 face value = $30/year.
- Issue date: The date that the bond was issued and begins to earn interest.
- Maturity: The lifetime of a bond; the face value/par value is repaid on the maturity date.
- Price/market value: What a bond sells for on the secondary market.
- Yield: A bond’s rate of return (the gain or loss compared to the initial investment) if held to maturity. It’s based on the price and coupon of the bond.
Let’s look at an example.
Imagine a major city wants to borrow $50 million from investors to build a new bridge. They decide to sell 50,000 bonds at $1,000 each to raise the needed $50 million.
Now, let’s say the coupon rate is set at 3%, and will be paid semi-annually. The bond’s term is 10 years.
If you buy one of these bonds, you’ll receive $30 per year in interest in two $15 payments. In 10 years, if all goes well, you’ll be paid $1,000.
How do you make money with bonds?
There are two ways to make money investing in bonds: you can buy bonds directly, hold them, and collect interest payments until their maturity date (like the above example) or you can buy existing bonds on a secondary market (often at a discount) and try to sell them for more than what you initially paid. In either case, the bondholder receives interest payments at the coupon rate that was determined at its issue date.
Bonds, like stocks, are traded between investors on a secondary market. While stocks are traded on exchanges, most corporate bonds are traded “over the counter” (which is just a way of saying they are traded without an exchange or broker) because their complexity and diversity makes them difficult to list on an exchange.
What are the risks of investing with bonds?
While bonds are generally considered safe, they do carry some risk.
Thankfully, bond ratings make it easier to understand the default risk of your investment.
Corporate bond rating
Credit rating agencies (like Standard and Poor or Moody’s) look at the financial health of bond issuers and assign ratings to individual bonds that let you know the reliability of the issuer. It’s basically a credit score based on how likely the issuer is to repay the loan.
In general, the higher the bond’s rating, the lower the coupon needs to be because there is less risk of default by the issuer. The lower the bond’s rating, the higher the coupon needs to be in order to entice investors to take a bigger risk. Bonds with exceptionally low credit ratings are called junk bonds or high-yield bonds since a higher yield is needed to make it worth the risk.
Even though bond ratings are reliable, you should always do your own additional research.
Liquidity risk is the risk that an investor may have to sell their bond at a lower price than expected. While selling a government bond isn’t usually a problem, selling corporate bonds can be difficult if there aren’t enough interested buyers.
When you buy a bond, you’re committing to a rate of return for the entire time the bond is held. Some bonds can be held for 10 years or more, so what happens if the cost of living increases dramatically during that time?
Basically, you lose purchasing power and might even reach a negative rate of return when inflation is factored in. For example, if you’re earning a 3% rate of return on a bond but inflation grows at 4% after you purchase it, the true rate of return is -1% because of a decrease in purchasing power.
Interest rate risk
It might seem backwards, but interest rates (the cost of borrowing money) and bond prices have an inverse relationship — as interest rates fall, bond prices rise and as interest rates rise, bond prices tend to fall. This is because when interest rates are declining, investors try to lock in the highest rates they can by buying existing bonds with coupon rates higher than the market interest rate. The increase in demand increases bond prices.
Conversely, when interest rates increase, investors try to get rid of bonds that pay lower interest rates, which forces bond prices down.
For example, say you buy a five-year, $1,000 bond with a 3% coupon rate. Then, market interest rates rise to 4%. You might have a hard time selling the bond with a 3% coupon rate because there are newer bond offerings with better interest rates available (meaning higher coupon payments). This lower demand triggers lower prices in the secondary market.
Types of bonds
Different types of bonds carry unique risk levels, earning potential, and other advantages and disadvantages.
Bonds issued by the government are considered one of the safest investments on the market because a government can always tax their citizens to meet its obligations.
However, because the risk of default is low, interest rates on government bonds are also usually low.
These are issued by local governments and municipalities to fund specific projects, like renovating an elementary school or building a highway. Municipal bonds come with more risk than government bonds because the issuer is much smaller.
These are bonds issued by corporations. Corporations have a higher likelihood of going bankrupt compared to governments, so corporate bonds usually come with more risk (and higher potential returns) than government bonds. However, high-quality corporate bonds are still considered a relatively safe and conservative investment.
You can tell if a bond is high-quality by its bond rating.
Bond ETFs are exchange-traded funds that invest in fixed-income securities like government and corporate bonds. If you’ve never heard the term before, an ETF is a bundle of securities that trade as one unit (check out this blog we wrote for more details!).
Unlike most individual bonds, bond ETFs are traded on major stock exchanges, providing investors with the same level of ease and convenience as stock trading. You can even trade bond ETFs on the Flahmingo app!
Bond ETFs never mature because the bonds that make up the fund are usually sold by the fund manager before they reach their maturity date. This makes investing in bond ETFs a little more risky than investing in an individual bond, since there’s no guarantee you’ll earn back your original investment. However, bond ETFs do provide the benefit of diversification – and most of them offer monthly coupon payments!
Pros/cons of investing in bonds
- Bonds have fixed returns. You know exactly how much your returns will be.
- Bonds are less volatile than stocks.
- Bonds come with credit ratings that help you cut down on the research time necessary to choose the best option.
- Bonds are generally safer investments than stocks. For example, government bonds are much less risky than stocks because they’re backed by the government. Also, the fixed interest payments of bonds significantly reduces risk.
- Again, bonds have fixed returns. Even though fixed payments provide safety, your investment will never grow beyond the interest payments you receive (unless you sell the bond before maturity for a capital gain).
- Some bonds aren’t very liquid, especially compared to stocks. It can be hard to sell if there aren’t enough buyers — you might have to sell for less than you could.
- Bonds come with multiple types of risk: default risk, liquidity risk, inflation risk, and interest rate risk. While bonds are generally considered less risky than stocks, they’re not risk-free.
The bottom line
We’re really only scratching the surface of bonds – but we hope you feel more informed about the basics! Even though bonds are generally described as safe investments, it’s always important to do your research and understand the risks of any financial decision.