The bond market is a safe harbor when the stock market starts going pear shaped, or just feels a bit wobbly. They come in all shapes and sizes from Treasury to junk, and are often a very strong option for someone looking to diversify their portfolio with a bit of stability. Here’s what you need to know about bonds and bond investment.
What is a Bond?
Bonds are structured debt sold by corporations, municipal governments or the federal government. A bond note is paid off over a period of years called its “term to maturity.” At the end of this period the bond is considered mature and the borrower has to pay back the full value of the loan, typically the face value of the bond. During the term of maturity the borrower makes periodic interest payments on the note.
So, for example, say you purchased a 30 year U.S. Treasury bond with a face value of $100 and an interest rate of 2%. The 30 year Treasury bond pays bi-annually. In this case every six months for the next 30 years you would receive a payment of $2, the interest on your bond. At the end of 30 years the bond would mature and you would receive your $100 dollars back.
Note that while most bonds are structured this way, not all are. For example, the U.S. savings bond does not make regular interest payments. Instead, it pays the interest in one lump sum when the owner redeems their bond for its face value. There are also zero-coupon bonds, which sell below face value instead of issuing interest.
A bond is a loan. It is you, the purchaser, lending this amount of money to the issuer for a period of time in exchange for interest payments.
Bond Risk and Ratings
Bonds are considered a highly safe investment, but that doesn’t make them entirely risk free. The bond rating system ranks bonds based on the creditworthiness of the issuing institution. Think of it like a credit score for corporations.
The higher a bond’s rating, the safer it is as an investment. However, as with all investments, this means that it will also pay a lower rate of interest. The inverse is true as well. Low-rated bonds pay better rates of interest, but that’s because they come with an increasingly significant risk that the issuer will default on their note. In that event you will lose both future interest payments and the repayment of your principal.
Generally speaking the bottom half of both ranking systems are considered “junk bonds.”
The three bond rating agencies are Standard & Poor’s, Moody’s and Fitch. Standard & Poor’s and Fitch rate bonds on a scale from AAA to D. Mood’s rates bonds from Aaa to C.
There are two ways to invest in bonds:
The Primary Market
In the primary bond market, you purchase bonds directly from the issuer. For example, when you buy a Treasury bond from the United States government you have participated in the primary bond market. In this format, you have directly lent money to the issuer. You receive the bond in exchange and are now entitled to regular payments.
The Secondary Market
The secondary bond market is where investors swap bonds among themselves. Say you purchase a 20 year, $1,000 bond from ABC Corporation at 3% interest. You could either hold this bond for two decades or you could sell the bond to another investor. In the former case, your profit would come from the note’s long term interest payments. In the latter case, your profit would come from selling the bond for (hopefully) more than you paid for it.
The price of a bond is influenced by several factors, including: The interest rate it pays (higher interest notes have more value); the term of maturity (notes with more years left until maturity may have more value because they will pay more interest); and the bond’s rating (investors will pay less for riskier notes).
The secondary bond market works by balancing time value of money against security. Investors sell bonds on this market when they want their principal back sooner rather than later. They don’t want to wait 20 years, they want to move their money elsewhere immediately. Investors buy bonds on this market when they want a safe investment. This investor wants the guarantee of a long-term interest payment more than they want liquidity.
This bond market plays an essential role in helping companies raise capital because it makes bonds a more liquid investment. While we have used small numbers in our examples, investors on the primary market typically buy bonds for hundreds of thousands, or even millions, of dollars. It would be far more difficult for issuers to get this loan if investors thought that money would stay locked away for decades at a time.
The Bond Market And Stocks
Prices on the secondary bond market often reflect the perception of the stock market.
When investors are confident, prices on the bond market are generally weak. Investors don’t want their money tied up in multi-decade, low-yield investments. They want their money working in lucrative assets such as stocks. As a result, bondholders typically have to accept much less money in order to sell their bonds. During strong markets bonds often sell for less than face value as bondholders take losses simply to get their money back into the stock market.
The opposite can happen when investors are nervous.
During a bear market investors typically seek safe investments. They don’t want to leave their money sitting in a checking account and certainly don’t want it in now-fickle stocks. As a result prices on the secondary market will rise. Bondholders can sell bonds for more money, typically above the face value of the note, as buyers simply want some form of safe return.
Bond Advantages and Disadvantages
A bond is typically one of the most reliable investments you can make. Well-rated bonds rarely default, allowing you to build out a safe harbor in your portfolio. On top of this the interest payment structure of most bonds allows you to create a regular income stream. Every several months you will receive a set, scheduled payment. This is highly valuable in a portfolio.
However bonds also return very low yields compared to a stock or typical mutual fund. This is the tradeoff for that degree of reliability. Your money will be safer than it would be in the stock market, but it will earn less (potentially significantly so).
How To Invest In Bonds
Bonds are harder to buy and sell than stocks.
To buy and sell bonds you have to work through a broker. There is no equivalent of the stock exchange for either the primary or secondary bond markets. As a result, you will have to find an investment broker that you trust and who charges a reasonable fee.
Unless you already have a broker who you work with regularly, you should probably seek out one who specializes in the bond market. FINRA, the Financial Industry Regulatory Authority, has a site to help you find brokers near you and check their credentials and professional history. This is a valuable tool, especially for first time investors in the bond market.
The exception to this is U.S. Treasury bonds. Those are made available directly to the public through the Treasury’s website.
The Bottom Line
Bonds are generally considered a safe investment and a fine way to diversify your portfolio. They can offer a steady income stream without much risk. While returns tend to be lower than that of bonds or mutual funds, volatility and risk decrease as well.
However, investing in bonds means locking your money away for a very long time. Unless you have the sophistication to participate in the secondary market, buying a bond typically means keeping that principal locked away for years, maybe even decades. This can become particularly problematic if inflation catches up with your bond’s interest rate. If you have a bond paying back 2% in a market with 2.1% inflation, you have functionally suffered a loss of 0.1% that year.
- If you aren’t sure where bonds fit into your investment portfolio, you may want to consult a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Do you know how bonds can affect your investment risk tolerance? How much will their value grow over time? What kind of bite will taxes and inflation take out of your investment? SmartAsset’s investing guide can remove some of the mystery from bond investing.
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