What is a Bond?
A bond is like an IOU for a loan you’ve made to an institution like the government or a corporation. Similar to when you take out a car loan or a mortgage, when the government or a corporation borrows money from you they do so for a certain period of time at a certain rate of interest. Generally, when the stock market is on a roller-coaster ride, bonds can help steady a portfolio because they tend to be a safe investment tool to help balance the overall risk in a portfolio.
When you purchase a bond you are lending money to the issuer, who can be a corporation, the government or a government agency. In return for the loan the issuer promises to pay you (the bond investor) a specific rate of interest known as the “coupon rate”. You are paid the interest on a predetermined schedule (usually quarterly) for the life of the bond. The life of a bond refers to the period of time the
issuer has to repay the investor. The issuer also promises to repay the face value when the bond matures (i.e., comes due). The face value is also known as “the principal” or the “par value.” Most bonds are issued with a $1000 face value.
While all bonds share basic characteristics such as terms, rates, and par values (the face value, or named value of the bond – usually $1,000), they are not all alike. One of the major differences is that they’re issued or sold by four distinct entities in the U.S. Corporations issue bonds to raise money for expansion, research and development, and other expenses of doing business. While corporations can also raise money by selling new stocks, they may prefer bonds because the existing stocks lose value when new stocks are issued. Municipal governments, such as states and cities, sell bonds called “munis” to fund projects for the public good like building bridges, sewers, roads, and schools. The U.S. Treasury also issues bonds to meet its regular and unusual obligations. And finally, government agencies issue bonds to raise money to do their work, such as provide mortgages and student loans.
For the purposes of this lesson, we will be discussing only “investment grade bonds” which are the highest rated by Moody’s, Standard & Poor’s, and Fitch. (the main investment rating services in the United States). A bond that is rated investment grade is considered to have the least chance of missing interest payments or failing to pay back the principal (face or par) value.
Bonds are also known as fixed-income investments because the investor knows the rate of interest and the interest payment schedule in advance of purchase (). Bonds are often included in a diverse investment portfolio. There are a variety of bonds available. Described below are the bonds most familiar to individual investors:
Corporate bonds - Bonds are major sources of corporate borrowing. Debentures, the most common type of corporate bond, are backed by the general credit of the corporation, while asset-backed bonds are backed by specific corporate assets, such as property or equipment.
Municipal bonds - Millions of bonds have been issued by state and local governments. General obligation bonds are backed by the full faith and credit of the issuer, and revenue bonds by the income generated by the particular project being financed.
U.S. Treasury bonds - US Treasury bonds are backed by the full faith and credit of the United State government. When the government spends more than it collects in taxes and other revenues, it issues Treasury notes, bills, and bonds to borrow the money to pay the difference. Treasury bonds have the longest term or period of time before the loan must be repaid (10 years or more). Treasury bills have the shortest (less than two years).
Yield refers to the return the investor earns. The simplest version of yield is calculated by using the following formula: yield = annual interest (or coupon amount)/price. When an investor buys a bond at par value, yield is equal to the interest rate. When the price changes, so does the yield. The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, you'd say the bond's price and its yield are inversely related. Be sure to take a look at Project:Invested’s page on bonds. It reviews bond basics, the different types available, as well as recommendations for every stage of an investor’s life.
Researching Bonds
It is important to research bond investments. There are a number of key variables to consider when purchasing bonds for your portfolio. The bond’s maturity, redemption features, credit quality, interest (or coupon) rate, price, yield and tax status help determine the value of the bond and how well it meets your investment needs. Investors want to know the risks in buying a bond. They can get a bond’s rating information directly from rating services, financial press, or from a broker or financial adviser. Standard & Poor's, Moody's Investors Service, Inc., and Fitch are a few of the more popular rating services.
Here are two websites you can visit two help you research bonds:
http://finra-markets.morningstar.com/BondCenter/
Here is a link to a website that gives more tips on how to research bonds: https://www.thebalance.com/how-to-research-and-buy-bonds-2466535
Want to learn more about bonds? Check out this page with tons of useful info: https://www.investopedia.com/terms/b/bond.asp