You’ve heard of the saying, “It takes money to make money.” Many large organizations possess the talent to make money grow while others need to seek out “seed money”—enough capital—to fund their numerous ventures. For this reason, organizations borrow money and they borrow it from you in the form of a bond.
Bond by Definition
Simply put, a bond is an agreement. You agree to let the borrower (issuer) use your capital until a specified date (maturity date) when it will be returned. In addition, the issuer will pay interest at a specified rate (coupon rate). Typically, interest is paid every six months.
Bonds are commonly referred to as fixed-income securities and are often used by investors to help diversify a portfolio and reduce its volatility and risk. There is generally less risk in owning bonds than in owning stocks because bonds are obligations to the lender, which are more difficult to write off than the equity you hold with common stock. For example, a bankrupt company’s stock can be worth zero while its bonds may still hold some value. Bonds also tend to provide a higher and steadier income than a money market or savings account. In spite of their relative safety and steady income, stocks have historically seen higher returns over longer periods. But don’t be blinded by dollar signs; safety is underrated too often.
The federal government issues bonds in many different forms:
- Treasury bills (T-bills)
- Notes (T-notes)
- Bonds (T-bonds)
- TIPs (Treasury Inflation-Protected Securities)
- U.S. savings bonds
These securities, collectively known as treasuries, are backed by the full faith and credit of the U.S. government. While bonds are not “guaranteed” investments, the likelihood of the federal government defaulting on payments is minimal.
Treasuries serve various purposes. Some of these bonds are short term while others are longer and some are designed to protect investors from inflation or changes in interest rates. If you have a specific need, there is probably a bond that’s right for you and the income earned on treasuries is only taxed at the federal level.
Corporations also benefit from borrowing money. Like people, businesses can have good or poor credit ratings. This rating is one of the best tools investors have to judge a borrower’s ability to keep their word—or their bond. We can broadly categorize corporate bonds as investment grade or high yield. Investment grade issues are less risky and pay lower returns while high yield issues have a greater risk of default in exchange for higher returns.
Local governmental organizations are often involved in issuing bonds. There are basically two types of municipal bonds: General obligation bonds and Revenue bonds. General obligation bonds are considered the most secure, offer the lowest interest rates, and are often used for infrastructure and capital improvement projects. In addition the municipality must pay back the bondholder out of general revenue dollars. Revenue bonds will pay the lender from future income generated by the anticipated project they’re funding (e.g., income generated from a new water utility). These bonds hold a higher risk and offer higher interest rates. Interest gained from municipal bonds is often exempt from federal tax and the issuing state’s income tax.
Mortgage bonds are also somewhat common. Mortgage bonds, or mortgage-backed securities, are secured by a pool of mortgages from either real estate or other property such as equipment. Historically, mortgage bonds offered a great deal of protection. But, when property values fall or payments are missed, mortgage bond holders may be at risk. The average mortgage bond tends to yield a lower rate of return than traditional corporate bonds.
It is important to note that bonds are debt securities and inherently carry some risks. Three primary risks include:
- Interest rate risk – When the general interest rates rise, a bond’s value decreases. For instance, if rates increase to five percent then your bond fixed at four percent is worth less in the secondary market so it would need to be “discounted” in order to sell it to someone else. Thus, the bond decreased in value. The opposite is true if rates fall to three percent and your bond is fixed at four percent. It is therefore worth more in the secondary market where it can sell for a premium, thus it increases in value.
- Default risk – This occurs if a company or municipality cannot pay back the loan. In the case of a corporate bankruptcy, bond owners usually have a right to company assets before shareholders do. Still, there are never any guarantees in investing. Bond issuers may not be able to make interest payments or possibly not pay back the principal amount.
- Liquidity risk – With bonds, you do not receive money for a specified period of time, thus limiting your ability to be liquid.
Other various risks involve inflation, maturity dates – which affect duration (a measure of interest rate sensitivity) of interest payments and when you’ll receive your principal back – and callable bonds – which permit the issuer to call bonds back prior to the maturity date because of changes in interest rates.
What to do next
- Meet with an investment advisor to discuss what kinds of bonds fit within your portfolio and your investment plan.