Bonds are loans or debt issued by companies, local municipalities, and governments to raise capital or money. Bond investing is the buying and selling of these securities. Bonds can add diversification to your investment portfolio and provide steady income, unlike most stocks.
💡 Fun Facts…
| 1) The first bond was issue in 2400 BC to guarantee the payment of grain |
| 2) In 1941, Series E bonds were issues to help fund the United States’ WW2 efforts |
How do bonds work?
Bonds are loans or IOUs issued by the above named entities in order to raise money. Bonds issued by the federal government are known as Treasury Bills or T-Bills. The purchase of bonds means you are lending out money for a stated period of time, usually from 1-30 years. In exchange for lending money, you get an interest payment, usually every 6 months. The interest rate is called the coupon. When the bond expires (at maturity), you get your original principal back, known as the face value. For example, if a company issues a bond with a face value of $1,000 and a coupon rate of 6.5%, the bondholder will receive a payment 0f $65 every year, and will receive the $1,000 face value when the bond matures.
Bond prices go up and down based on the general market interest rates. The price of bonds moves in the opposite direction of interest rates. As interest rates rise, bond prices decrease and visa-versa.
Factors To Consider When Investing in Bonds
There are several things bond investors should analyze when deciding how to invest. The credit rating of the bond issuer has a direct effect on the interest rate you will receive. A higher rating indicates less risk, and therefore a safer investment, and will result in a lower interest rate. Conversely, a lower credit rating indicates higher risk and will yield a higher interest rate. There are several third party companies that rate bonds, including Moody’s, Fitch and Standard & Poor’s. Bond ratings usually range from AAA, the highest rating, to D, the lowest rating, with intermediate ratings such as A, B, and C. The stronger the financial profile, the higher the rating a bond will receive. The rating indicates the issuer’s ability to pay the interest on time and face value at maturity. AAA-rated bonds represent the highest credit quality, indicating the issuer’s ability to repay the bondholders’ principal and interest on time and in full. These bonds are considered very low risk and typically offer lower yields than lower-rated bonds. D-rated bonds are the highest risk and pay the highest interest rates, and are often referred to as junk bonds. Bonds rate in between these two have varying levels of safety and risk associated with them.
Another factor to consider is the length of the bond, or duration, which affects its sensitivity to market interest rate changes. The longer the maturity date, the higher interest rate due to the higher risk. Shorter term bonds will offer a lower interest rate due to their increased safety. Some bonds issued by government agencies, both local municipalities and federal, offer tax incentives to buy their bonds, by making their interest payments tax free. Many investors favor these types of bonds as they offer a benefit over other types of bonds. There are also a variety of other bond features that one can consider such as being convertible to stock or being a “senior” bond.
Where are bonds headed?
Interest rates have been rising rapidly over the last few months, as The Fed has raised rates to try to combat inflation. What does this mean for bond investing? While current bond values have decreased due to the rising interest rates, new bonds are offering higher, more attractive rates. However, some experts predict that interest will peak in the short term and will stabilize. It is always good to diversify your investment portfolio and bonds offer an alternative to stocks. If you’re new to bond investing, you should consult with an advisor before making any changes to your strategy.
OPINION
Bonds are a different type of investment that many people don’t fully understand or use in their portfolio. Bonds can provide a significant type of diversification besides just owning stocks. They are safer than many other types of investments and can provide guaranteed income. If you’re new to bond investing, research online to learn how they work before taking the plunge. Make sure you understand how you can make a return as well as the tax implications.
