What Are Bonds And How Do They Work?

Typically, the rate at which interest is paid and the amount of each payment is fixed when the bond is offered for sale. That’s why bonds are known as fixed-income securities. It’s also why a bond may seem less risky than an investment whose return might change dramatically in the short term.

A bond’s interest rate is competitive. This means it is comparable with other bonds of similar risk and term being issued simultaneously and reflects the cost of borrowing in the economy at large.

Bonds make periodic interest payments, which is known as their coupon rate. To find the coupon rate, divide the annual payments by the bond’s face value.

Bonds are the primary way they raise money to fund capital improvements and keep everyday operations running when revenues, such as taxes and tolls, aren’t available to cover current costs.

Any bond’s life or term is generally fixed at the time of issue. It can range from short – (usually a year or less) to intermediate – (two to ten years) to long-term (more than ten years). Generally speaking, the longer the term, the higher the interest rate offered to compensate for the additional risk of tying up your money for a lengthy period. If interest rates are low and seem likely to rise reasonably soon, you may decide to stick with short- or intermediate-term bonds.

What are the types of Bonds?

You can buy bonds issued by US companies, by the US Treasury, by cities and states, and by various federal, state, and local government agencies. Each has different sellers, purposes, buyers, and levels of risk vs. return. In addition, each type of bond has its advantages and disadvantages. 

US Treasury Bonds. These are issued by the US government and are considered the safest possible bond investments. However, they also offer the lowest return. Several types of Treasury bonds (bills, notes, bonds) differ based on the length of time till maturity. US Treasury bills are bonds with a maturity of one year or less; Treasury notes have a maturity of between two and ten years; Treasury bonds have terms of 30 years.

Corporate bonds. It is a debt obligation issued by a company to raise money. They offer higher rates of return because they are riskier than government bonds. But they are also stable, and as long as the issuing company stays in good shape, bonds typically hold up well in all economic conditions.

Municipal bonds. These are bonds issued by various cities, states, and other local governmental organizations to provide public services or finance public initiatives. Municipal bonds can have tax benefits but have slightly lower interest rates than corporate bonds. However, compared to government-issued bonds, they are a little bit riskier. 

Agency bonds. These are securities issued by either government-sponsored enterprises or government departments other than the Treasury. For example, Fannie Mae or Freddie Mac sell bonds guaranteed by the federal government.

Many overseas companies and governments also sell bonds to US investors. When those bonds are sold in dollars rather than the currency of the issuing country, they’re sometimes known as Yankee bonds. The advantage for individual investors is that they don’t have to worry about currency fluctuations in the bond’s worth or interest payments.

How does Bond trading work?

When companies need to raise money, they may issue bonds. Investors can buy bonds from brokers, banks, or directly from certain issuers.

You can buy newly issued corporate, municipal, and agency bonds or bonds trading in the secondary market through your broker or from certain banks. In the secondary market, you buy bonds that are being sold at some point after issue by a previous investor. Most already-issued bonds are traded over-the-counter (OTC), a term that means over the phone or by computer. Bond dealers across the country are connected via electronic display terminals that give them the latest price information. A broker buying a bond tries to find the dealer offering the best price and calls to negotiate a trade.

Brokerage firms also have inventories of bonds to sell to clients looking for bonds of particular maturities or yields. Often, investors make out better buying bonds their brokers already own – or make a market in – as opposed to bonds the brokers have to buy from another firm.

How do you make money from Bonds?

There are two ways to make money with bonds: income and capital gains. Conservative investors use bonds to provide a steady income. They often buy a bond when it’s issued and hold it, expecting to receive regular interest payments until the bond matures and the principal is paid back. Then, they can invest in a new bond. Other investors may trade bonds or buy and sell as they might with stocks, hoping to increase their total return.

It’s also possible to sell bonds at a profit when interest rates fall. For example, investors may be willing to pay more than the face value of an older bond paying 8% interest if new bonds are paying 5%. An increase in the price of a bond, or capital appreciation, may produce more profits than holding bonds to maturity.

There are risks in bond investing. Issuers could default. If interest rates go up, you can lose money if you want to sell an older bond with a lower interest rate because potential buyers will typically want to pay less than you spent to buy it. Inflation is another risk. Since the amount you earn on a bond usually doesn’t change, its value can be eroded over time. For example, if you have a 30-year bond paying $50 annual interest, the income will buy less at the end of the term than at the beginning.

What are the pros and cons of Bonds? 

Just like any investment, bonds have benefits and drawbacks. 

One advantage of buying bonds is that they’re a relatively safe investment. Bonds can act as a balancing force in an investment portfolio if stocks make up most of it. By diversifying your portfolio with bonds, you can reduce risk overall.

Another benefit of bonds is that they can provide steady income streams from interest payments before maturity. You can also make money if you resell the bond for more money than you paid for it.

Owning bonds can be a component of an investor’s balanced portfolio strategy because they are less volatile and more stable than stocks. In addition, the diversification that bonds add to your portfolio may be the main advantage of investing in bonds. Bonds have some risk even though they are typically considered “safe.” Here are some of the most common risks with these investments.

Credit Risk. The bonds may default if the issuer doesn’t pay interest or principal on time.

Inflation Risk. The fixed income you receive from the bond loses value over time due to inflation, which can lower your purchasing power.

Liquidity Risk. It means that there is the possibility that the market won’t have enough buyers to quickly and, at the current price, buy your bond holdings.

Interest Rate Risk. Interest rate changes can affect a bond’s value. Because bonds are a relatively long-term investment, you’ll face the risk of interest rate changes. The face value of the bonds, plus interest, will be paid to the investor if they are held until maturity. As a result, the bond’s value could be higher or lower than its face value if sold before it matures.

What are things you must know about bonds?

Bonds are a way for an organization to raise money. However, there are some critical features to look for when considering a bond. 

Maturity. This is the date when the bond’s principal or par value is paid to investors, marking the conclusion of the company’s bond obligation. All bonds have maturity dates, after which the full principal must be repaid to avoid default.

Bond price. Bond price varies in response to changes in the economy’s interest rates. The bond price will typically increase if the borrower’s credit risk profile changes, making it more likely that it will be able to repay the bond when it matures. 

Bond Ratings. A bond’s interest rate is tied to the creditworthiness of the issuer. Businesses and financial institutions often use credit ratings to evaluate how much risk they would take by entering into a financial agreement with another firm, described as a counterparty.

Interest rates. Bond prices in the market react inversely to changes in interest rates. Since it is more difficult to anticipate future market developments, the longer the time until maturity, the greater the interest rate risk an investor bears. 

Bond Yields. Yield is the income that a fund pays on a monthly or quarterly basis. In other words, it is what you earn, expressed as a percentage of what you invested. 

Coupon. Bondholders typically receive interest payments every year or every two years, represented by the coupon amount. A bond’s coupon rate is the relation between the value of the bond’s coupon payments and its face value, expressed as a percentage. 

Why do companies issue Bonds?

For corporations, issuing a bond is like making an initial public offering. An investment firm helps set the terms and underwrites the sale by buying the bonds from the issuer. In cooperation with other companies, known as a syndicate, it then offers the bonds for sale. The underwriter profits from the fees the issuer pays and the spread between the cost of buying the bonds and what it earns from selling them. If demand lags, it may need to reduce the price and even take a loss.

After issue, bonds trade in the secondary market, which means they are bought and sold through brokers, similar to the way stocks are. The issuer gets no money from these secondary trades. US Treasury issues, with a face value, or par, of $100, are available directly to investors through an online system called Treasury Direct or through brokers. Most agency bonds and municipal bonds are sold through brokers, who buy bonds in large denominations and sell pieces of them to individual investors. 

What Are Bonds And How Do They Work by Inna Rosputnia

Wishing you a great week!