In this article, we’re going to explore how do bonds work, including what bonds are, why they exist, and how they actually work. Let’s get into it.
What are bonds?
Firstly, what are bonds?
Bonds are essentially just loans. They’re financial agreements where the borrower (i.e., the bond issuer) agrees to pay interest to the lender (investor) at a specified interval until the end of the term.
Put differently, a bond is basically an IOU (a promise to pay back money).
You lend money to a company or government by purchasing the bond and they agree to pay you interest (the coupon) for lending them money. That’s called “coupon rate” or “coupon.”
When the company/government pays off the loan, you get your original investment back (sort of). At the end of the bond’s maturity date, the bond issuer pays the “par value” (aka face value).
Bonds are often described as fixed income securities because the income they provide for investors is largely fixed.
Why do bonds exist?
Bonds exist because investors don’t like taking on too much risk for one principal investment such as stocks or shares.
In other words, bonds allow you to diversify your portfolio with lower risk and still get some return.
That’s from the investors’ standpoint.
From the issuers’ standpoint, a bond is a source of capital, or a source of finance.
It’s a way for governments and companies to raise money for their investments.
How do bonds work vis-a-vis stocks?
The difference between stocks and bonds are that bonds are generally safer investments. It is also important to note that even though bonds are safer investments, they don’t come without risk.
Issuers of bonds – particularly corporations/companies – can go bankrupt, or default on their payments. For you as an investor, this could result in losing your entire bond invested capital.
There’s also interest rate risk (the risk of interest rates changing) which bonds, depending on their maturity dates, can be particularly susceptible to.
When you buy stocks, you earn money by:
- dividends, and
- capital gains (appreciation in the stock price)
Income from bonds on the other hand include:
- interest (coupon payments), and
- par value (aka face value)
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The par value may be different from what you paid to buy the bond, but it is to a large extent, just a lump-sum repayment by the issuer of the bond.
Importantly though, note that while some stocks pay dividends, others do not.
Dividends are not legal obligations nor legal requirements for companies. They can choose to pay dividends, but they certainly don’t have to.
Coupons (interest payments) of bonds however are legal obligations. Issuers of bonds have to pay interest on the bonds if that was promised at the time of issuance.
Who issues bonds?
Bonds are issued by a variety of entities, including governments, municipalities (aka local governments), and companies.
What are the types of bonds?
There are dime a dozen different types of bonds. And the “types” also vary depending on how you categorise them.
For example, we could categorise bonds based on their interest rate as:
- fixed rate bonds (those that pay a fixed rate of interest)
- floating rate bonds (those that pay interest at a variable interest rate that is set by the market)
Or based on their tax status as:
- taxable bonds
- tax-free bonds
Alternatively, we could categorise bonds based on the issuers:
- corporate bonds
- government bonds
Or based on their “investment quality”, including:
- risk free bonds (those that are virtually guaranteed to never default)
- investment grade bonds (those that are unlikely to default)
- junk bonds (those that are likely to default)
We could also categorise bonds based on their time to maturity:
- short term bonds
- long term bonds
Alternatively, bonds can be categorised based on their risk contingencies:
- secured bond (one that has a collateral backing their payment)
- unsecured bond (one that does not have any collateral backing them)
- convertible bond (one that can be converted into a different security/asset at a future date)
3 Main Types of Bonds
We could go on showcasing more ways to categorise bonds.
But regardless of whether you categorise/label bonds based on their interest rate, tax status, issuers, investment quality, time to maturity, or any other attribute…
If you were to strip bonds to their bare-bones core, and into their simplest form, you’ll see that there are in fact just 3 types of bonds:
- straight/vanilla bonds
- perpetual bonds (aka Consols), and
- zero coupon bonds (aka “deep discount bonds”)
Straight/vanilla bonds and perpetual bonds are examples of a coupon bond in that they both have coupon payments.
A zero coupon bond on the other hand, doesn’t pay any coupons (i.e. no interest payment). Instead, it only pays a par value / face value at the bond’s maturity date.
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How do bonds work?
Now that you know what bonds are, who issues them, and why, let’s think about how they actually work.
Thinking about how bonds work requires thinking from different perspectives. 2 main perspectives:
- investor’s / bondholder’s perspective
- issuer’s perspective
Investor’s / bondholder’s perspective
From the investor’s perspective, bonds work by allowing investors to create well diversified portfolios.
Bonds allow investors to earn greater returns for the same level of risk. Or indeed, earn the same amount of return for a lower level of risk.
Bond issuer’s perspective
How do bonds work for companies?
When a company needs to raise money, it can:
- ask a bank for a loan;
- raise money from shareholders; or
- issue bonds
Banks may not always be willing to lend to businesses. This could be for a whole host of reasons, including because of the bank’s own risk tolerances and preferences.
Raising money from shareholders can be a very expensive affair. And it also results in giving up a share of the company in that shareholders receive ownership of the business.
Bonds are an alternative way of raising capital. They are like loans but issued by companies to investors so that companies borrow from investors rather than borrowing from banks.
Most companies issue bonds when they need to raise funds to finance their operations or invest in new equipment, land or buildings that will help them make more sales and boost profits in future years.
How do bonds work for governments?
Governments generally issue bonds when they need cash to pay for projects or operations.
Bonds issued by the Treasury of the US are called treasury bonds (or simply “treasuries”). The UK equivalent is called “Gilts”. Regardless of the individual country-level names used to describe government bonds, the principles are fairly consistent across the board.
The government sells its bonds to an investor such as a bank, pension fund, or individual investors, who buy the bond in the expectation of a return.
In exchange for the loan, the government typically pays interest (coupon payments).
The government repays its debt by:
- raising taxes on people and businesses;
- collecting other income, such as fines and profits from state-owned industries;
- issuing new debt over time
- printing more money (aka “quantitative easing”)
How do bonds work for investing?
If you’re considering investing in bonds, then it’s worth exploring and learning about the core bond characteristics.
All bonds have the following characteristics:
- bond price (which is the price you pay to buy/sell the bond)
- coupon rate (this reflects the interest payment in percentage terms)
- yield to maturity (aka bond yield, this is the actual/effective interest rate of the bond)
- time to maturity (aka bond’s maturity date, which is when the bond matures)
- par value (aka face value, which is the lump sum payment paid at the bond’s maturity date)
This does come with a bit of a caveat. Some bonds don’t have all 5 characteristics. For instance, a coupon bond will pay an actual coupon, and thus have a coupon rate. A zero coupon bond on the other hand doesn’t pay any coupons, and thus won’t really have a coupon rate.
Similarly, a Consol pays coupon payments perpetually, and thus won’t really have a par value.
Now, we could actually create separate articles or even videos for each and every one of these different characteristics.
And we kinda have, in that we’ve created a whole course on how to value bonds. So if you’re seriously thinking about investing in bonds, you should definitely check out the course.
How much should you invest in bonds?
Bonds are a great way to keep your portfolio diversified and not put all your eggs in one basket. This holds regardless of whether we’re talking about corporate bonds or government bonds, although the latter will likely do better in reducing your overall risk.
But what is the right amount of investment in bonds?
In the “low interest rate world” of the 2020’s, it’s perhaps best not to view bonds as an investment to earn high returns. They don’t tend to offer high returns anyway, but the 2020s in particular, in a world with negative interest rates, the returns of bonds is perhaps embarrassingly low.
However, it’s constructive to invest in bonds to preserve capital and reduce risk.
That’s because bonds tend to rise when stocks fall (since everybody wants safety when the market goes down).
Their reasonably stable prices coupled with low correlations with stocks mean they’re very useful instruments to diversify your portfolio.
Focus on your risk tolerance
A bond’s reputation as a safe haven is based on the fact that its price does not drop too much even when stocks are falling.
In other words, although its returns are typically lower than those of stocks, they offer a more consistent return.
But again, especially in a world with low and negative interest rates, it is perhaps best to view bonds as an instrument to preserve capital vis-a-vis one to “get the most bang for your buck” so to speak.
When deciding how much to invest in bonds vs. stocks, it’s useful to think about how much risk you can tolerate.
If you can stomach a hiccup or two in the market while still seeing an increase throughout the year (or decades), then stocks will probably make more sense for your investment strategy.
If on the other hand, you really can’t tolerate volatility or sudden movements in the value of your investments, then bonds are likely the better choice.
You should of course always to rigorous research before investing any money, and if need be, consult an independent (fiduciary) financial adviser.
Alright, but hopefully you now know how do bonds work. For more information on the technical risks of bonds, see this article by BlackRock. If you’re looking to conquer bonds and learn how to value them rigorously, do check out our course below.
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