What Are Bonds?
A bond is a type of debt investment where an investor loans money to a company or other entity, such as the government. Bonds are issued for a defined period of time during which regular interest payments are made to the lender. At the end of that time period, the face value of the bond can be redeemed by the lender.
How Do You Buy/Sell (Trade) Bonds?
Much like stocks, you can trade bonds through a brokerage company or service. You can also purchase bonds directly from the U.S. Government through TreasuryDirect.
How Are Bonds Priced?
The initial issue price of a bond is the amount for which the issuer originally sells the bond. It can be the same amount or different from the face value or par value, which is the amount that the bond will be worth when it matures, or reaches the end of its issuance period. The face value is also the reference amount the bond issuer will use to calculate interest payments. The market price of a bond changes throughout a trading day, similar to stocks. Supply and demand forces apply here as well; however, prevailing interest rates influence bond market prices the most. Put simply, bond prices are inversely related to prevailing interest rates. If interest rates rise, the market price of bonds will fall, and vice versa. I’ll include an example of this dynamic at the end of the post.
How Can Investing in Bonds Make You Money?
The main way bonds can make money is through interest payments. Bonds have a coupon rate, which is essentially the interest rate that the issuer of the bond will pay based on the face value. These payments are made regularly and vary from bond to bond. For example, U.S. Treasury bonds pay interest semi-annually. Like stocks, if the market price of your bond rises above the initial issue price, then you can sell it for a gain. Finally, if you hold your bond until the maturity date, you can redeem it at that time for its face value.
How Can Investing in Bonds Lose You Money?
One way that you could lose money is if the bond issuer goes bankrupt or defaults on the debt. Another way you can lose money is if the market price of your bond falls below the issue price and you sell it before reaching the maturity date.
Less Risky Business
While bonds are considered less risky than stocks, they are not without their own set of risks. One risk mentioned before is the risk of default. This risk can be assessed by looking at the bond’s credit rating. Depending on the ratings agency, they go from AAA (prime) to D (in default). Generally speaking, the higher the credit rating, the less risk of default. Another type of bond risk is interest rate risk. This risk stems from the relationship between bond prices and interest rates. This type of risk is highest for longer duration bonds. For example, let’s say you buy a 20-year U.S. Treasury bond with an annual coupon of 4%. The risk lies in the chance that interest rates could rise above 4% some time during those 20 years.
You’ve been warned. The following section contains gratuitous mathematical equations. As mentioned before, bond prices are inversely related to interest rates. To illustrate this, let’s go through an example. You purchase a bond from company XYZ for $100, which is also its face value. The bond pays a coupon of 5% annually, meaning you would get $5 every year (or $100 x 0.05 = $5). Shortly after, interest rates go up to 6%. Your bond does not look as attractive sitting at 5%. The price of your bond will fall until its yield equals 6%, the rate of newly issued bonds. To figure out the new price, the equation would be Y x 0.06 = $5 where Y is the new price of your bond. Solving for Y, you would get $83.33 as your new price. It works out: $5/$83.33 = 0.06 or 6%. Alternatively, if interest rates fall to 4%, your bond will increase in price until its yield equals 4%. Mathematically, that would be Y x 0.04 = $5 where Y = $125. Again, it works out: $5/$125 = 0.04 or 4%.
Disclaimer: Remember, I am just some random guy online. I’m not a professional financial advisor/planner. The contents of this post and blog should not be taken as financial advice.