What You Should Know About Investing in Bonds
Written by: Kristy Welsh
Last Updated: August 18, 2017
Bonds are a great core element to add to your financial investment portfolio and a good way to invest and grow your money. With interest rates plummeting, many conservative investors are looking beyond ordinary bank accounts for the first time. For those desperate for income and safety, like new investors, newly-retired seniors or those about to retire, investing in bonds might be a great alternative to other more risky investments.
If you are just beginning to consider investing in bonds, this article is meant to educate you on the basics of bonds and will help you to determine if this type of investment is right for you.
What Are Bonds?
A bond is similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency, or other entity known as an issuer. In return for that money, the issuer provides you with a bond which is a promise to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures.
Types of Bonds
Bonds can also be referred to as bills, notes, debt securities, or debt obligations. Among the types of bonds available for investment are:
- U.S. Government Securities
- Municipal Bonds
- Corporate Bonds
- Mortgage and Asset-Backed Securities
- Federal Agency Securities
- Foreign Government Bonds
To help determine which one is a good risk, companies like Moody's, Standard and Poors, Fitch, and Weiss Reports examine the credit quality of bonds and assign a letter grade like a report card. The highest grades all begin with "A" and a plus or minus sign is often attached, too. The more "A's", the better. Some of the best bonds are rated "AAA." Anything with a "B" or lower is considered below investment grade by many buyers, and they will not buy these bonds at all.
This letter grade, which is constantly changing, is one of the primary determinants of value. Should a formerly rock-solid bond received a lowered rating, its value will slide accordingly since bonds trade on the open market just as stocks do.
Let's look at the other component of a bond's value — its interest rate. Always remember that there is no such thing as a free lunch. A bond that pays significantly more interest than a similar bond maturing at about the same time is riskier.
Think back to your own daily life. Suppose you want to borrow a few dollars and several banks offer loans. One charges 5 percent, one charges 6 percent and one charges 7 percent for a similar loan. Suppose you borrow the money and pay 7 percent interest for it. Is it likely that you are too dim to know that you will pay less at the bank that charges 5 percent? If you are paying 7 percent for that money, you have previously shopped the cheaper banks and been turned down. Perhaps you overlooked a couple of credit card payments and the money was received late. Maybe you got into trouble at one point when you lost a job and your ability to pay suffered.
The same holds true in corporate life, too. Pay late, take on too much debt, stiff a few borrowers, and money will only be available at a high rate. This is the heart of the so-called “high yield” or “junk bond” market, so if those really high rates look appetizing, know what you are getting into. The bonds may default — i.e., go belly-up — leaving you with nothing.
Bond Interest Rates
Let's look again at interest rates. Besides the risk that the bond may just go bad, the second major risk in bonds is called “interest rate risk.” This is a fancy way of letting you know that if you have a bond paying 5 percent and new bonds of similar quality and maturities are now paying 6 percent, nobody will want to buy your more-poorly paying bond at full price.
A mathematical measure, called "duration," gives you a rough idea of how exposed your bonds are to interest rate risk. Duration is composed of a combination of time to maturity and frequency of interest payments. Compare a 30-year treasury bond paying interest at regular quarterly intervals and a zero-coupon bond or stripped bond of the same maturity, where all the accumulated interest is paid out in a single lump sum at the end. The durations will be very different even though both are 30-year bonds that mature at the same time.
On the normal bond, you are getting money back regularly to reinvest at the higher or lower interest rates prevailing at the time. In the zero of the same maturity, no money paid out until the end means that everything compounds for the entire length of the bond. This makes a bond that does not pay out interest regularly much more likely to move up and down in value. Therefore the duration is longer.
Why is this important? Well, you want to buy bonds that mature more quickly and have lower durations, if you believe interest rates will increase in the near future. When you believe interest rates are falling, you will choose bonds that run longer and have longer durations.
How the Bond Market Works
Let's examine how the bond market works. We are accustomed to looking at the interest rate, or yield of a bond, but for professional bond traders who buy and sell millions of dollars worth of these securities, the price is what counts. The price of the bond or how much it is worth if it sells today moves in exactly the opposite direction of the yield or interest rate.
Here is an example. Suppose you want to sell a 5-year bond that has 1 more years to go. When the bond was issued, it cost $1,000, a common value for newly-issued bonds, and the coupon or original yield at issue of the bond was 5 percent. That means that at the end of the term, you will receive your thousand dollars and $50.00 in income.
Now let's say that new bonds of identical cost and credit quality that will run for one year carry coupon yields of 6 percent and cost $1,000. If you buy the new bond, at maturity you will have the original investment of $1,000 and a return of $60 in interest. How will you sell your bond now? Nobody in their right mind will buy a bond that pays $50 when similar new bonds pay $60.
Here is what will happen. You will sell your bond for $10 less. Instead of selling the thousand dollar bond for a thousand dollars, known as its par value, you will sell it for $990, give or take.
At maturity, the buyer will get his fifty dollars in interest and an additional profit of t$10 as the bond he paid $990 is now worth an even thousand. You have lowered the price of your bond and the yield increased to 6 percent. This yield to maturity is now 6 percent even though the original coupon or stated interest rate remains 5 percent. The adjustment may be slightly less or more than an exact $10 because the frequency of interest payments and the length to final maturity are part of the calculation. If the bond pays no interest until final maturity, it will be hit a little harder than one paying out every quarter because interest can be reinvested at higher rates as it becomes available. A bond that runs longer will be more seriously hammered than one just about to mature when interest rates rise too.
The process works in reverse when interest rates fall. At that point, older bonds that pay more become more desirable and a buyer will pay over face value to get them. When interest rates are falling, bonds with more years until maturity and longer durations become much more valuable because they pay more for a longer time.
Is it a Good Thing When Bond Interest Rates Rise?
This is a major point of confusion for new bond buyers. Never cheer if interest rates rise while you are holding bonds. You will not be paid one extra dime above the original coupon yield, but if you have to sell the bonds you will not get their full value. Even if you stand pat, you are losing money because you are stuck with the lower rate until the bonds mature.
Many new investors are being lured into bond funds for the first time. Those tempting returns were obtained by rapidly falling interest rates. Should interest rates rise in the future, the gains will become losses and the worst losses will be in funds with the longest maturities.
What are some additional risks to bonds? Well, many corporate bonds, debt issued by companies, have "call" provisions. This means that when interest rates drop, they have the option of paying you off and taking away your valuable investment, just when you need it most. Even worse, you may not realize it has been called and leave the money in an investment account at your brokerage earning absolutely nothing at all until you figure it out.
How about mortgage bonds like GNMA's? They have unique risks. For example, most of us don't hold our mortgages to maturity. If better deals become available, we refinance, while rising interest rates make us hold onto our mortgages like grim death. When we receive a Christmas bonus, we may also put a little extra money towards paying down the mortgage so we can get that monkey off our backs sooner.
This presents two problems to mortgage bond investors. First, when that extra money is paid towards the mortgage it is disbursed to the investors. This money is not a gift nor does it represent a high rate of interest. Instead, it is part of the original investment returned before maturity. If you spend it, you are spending, not interest, but the original investment. Many new buyers have spent every dime of their returns as they received them and then discovered to their shock that there was no more money coming to them when the investment matured.
What is the second problem? The inconsistent duration of these bonds. What I mean by that is that although mortgage bonds typically pay more than treasuries while offering a reasonably high credit quality, they do not offer fixed maturities like treasuries. When you buy a treasury of a given length, you can count the days until it matures. The duration and sensitivity to interest rate movements is fixed and knowable.
Not so with mortgages. When interest rates rise, the duration will rise with it as few want to refinance. That means your durations are increasing just when you would like to see them shorten so you could get into a better investment. This will damage the price of your GNMA's or other mortgage bonds regardless of whether you buy them through a bond fund or own them yourself.
So how do you buy bonds? One option is through a professionally-managed bond fund. This can be the best way if you want to get into odd and particularly risky bonds like high yield or foreign bonds. It allows you to make periodic investments into the fund and pick up bonds a few dollars at a time instead of in units of a thousand dollars or more for a single bond.
If you go that route, the managers will monitor credit quality and interest rate trends. They will replace bonds that have been called and will hedge against currency fluctuations in bonds issued by foreign governments. Their large capital base will allow them to invest in riskier “junk bonds” since they can buy sufficiently different bonds that all are not likely to go bad at once.
But all of that comes at a cost. The managers of the funds have to receive salaries, and the man who sells you this fund may be entitled to a commission as well. The most dangerous risk lies in how these funds work. Unlike you, they cannot hold the bonds to maturity. They must constantly buy and sell bonds to maintain the duration and level of risk they promised their investors. That means returns will be reduced by transaction costs and losses due to interest rate risk may be amplified, especially if the trader makes a bad call.
Buying Bonds Through a Brokerage House
You may also buy, hold and sell bonds directly through a brokerage account. This offers the greatest variety of bonds at the lowest possible cost, but you will have to keep track of call provisions on bonds. You will ante up the full face value of the bond, pay commissions and be stuck with any losses if you sell at the wrong time. If you buy a GNMA, you will have to remember that some of the payments are your own money coming back to you to avoid spending it. You will not be professionally hedged against the rising or falling value of the American dollar if you buy foreign bonds. You may also have trouble selling the bonds at all if you pick strange stuff without an active market.
The advantage to this method is that you will know exactly what you own. You will be only be on the hook for commissions to buy and sell the bond at the time of your choosing and not have your investments traded frequently at substantial transaction cost. You can choose to keep something till maturity rather than sell at a bad time, unlike bond traders for mutual funds or banks who are forced to maintain constant durations in the funds they manage. You will not have to pay ongoing management fees or the cost of soliciting new business.
Treasury Direct Accounts
One of the best ways for new investors to buy bonds is a treasury direct account. This is a way to buy government bonds directly from the government at cost. Maturities range from as little as a few days to as much as 30 years.
New bonds are available on a regular basis and small investors will receive interest rates based on what large banks and financial institutions pay for the same bonds at auction. These large players enter what are known as “competitive bids.” They vie to get the government debt at the best return. Whoever is willing to accept less gets the right to buy the bonds. This keeps the cost of interest as low as possible for the government.
The little guy simply purchases the bond at the maturity of his choice by entering a non-competitive bid. In other words, he takes the price that the big players have set. When inflation heats up or better paying, safe investments are available, the big institutions want less government debt and offer poorer prices. That makes the interest rates rise.
Recent Bond Climate
When the investment climate becomes more risky, the stock market is down and prices of goods or services are flat or falling, safe government bonds are in greater demand, prices of the bonds rise and interest rates drop. This, plus massive purchases of government paper by the Federal Reserve Bank, is behind the low interest rates savers and investors in safe bonds are currently receiving. The rising demand for safe bonds over stocks or riskier bonds is also the reason that investments in better quality bonds and bond funds have risen and investment returns with them over the last few years.
Both stocks and more speculative bonds like junk bonds have been slammed as the credit crunch and bad investment climates forced frightened buyers to take what they could get in exchange for keeping their money safe.
But low interest rates are not a given. They can rise at any time as inflation picks up or the business climate improves, creating more demand for capital. At this time, when interest rates are at the lowest level in decades it is wise to limit investment in longer term bonds or those that are more speculative to avoid potential loss.
Creating a “bond ladder” or a series of purchases of bonds at varying maturities to limit risk and assure regular access to capital is a sound idea. To do this, you pick a maturity like a 5-year bond, and buy 1 each year so that in five years you will have a 1-year bond, 2-year bond, 3-year bond, 4-year bond, and 5-year bond. Or, if you have more money, you may stagger maturities by buying several bonds maturing at different times until you create your ladder.
Keep your maturities shorter when interest rates are low and rising, but when they start to fall, make a few final purchases of the longest maturities you feel comfortable holding, as you may not see such favorable rates for a long time.
To recap, bonds are nothing more than loans. You want to loan your money to the safest borrowers while getting the highest return. Unusually high returns should be investigated. A competitive market means that no one pays one red cent more for funds than he has to.
Avoid companies and governments on shaky ground. High yields may disappear and your investment with them. Rising interest rates hurt the value of existing bonds while falling interest rates raise the price and value of existing bonds. Call provisions in corporate bonds, prepayments in mortgage-based bonds and currency fluctuations in foreign bonds are additional risks.
In the words of Treasury Secretary Andrew Mellon: “Gentlemen prefer bonds,” and you may too.
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