Categorized | Bonds, Investing

Bond Basics – A Primer to the Bond Market


Railroad BondToday we’re going to revisit the basics of the bond market. Bonds are issued by companies and government entities in order to finance their operations. They are a form of debt, contrasted with stocks which are a form of equity (though some bonds can be converted into equity in a company, these are called convertible bonds). Bonds are generally underwritten and issued on primary markets for companies. For governments they are usually issued at auction to both banks and individuals. Bonds have a par value at issuance and pay an interest rate called a coupon. They can be redeemed at maturity date.

Dynamics of Bonds

There are many factors that influence how much a bond will be worth.  Perhaps the most important factor is the market interest rates. Bonds are usually issued with fixed interest rates so when market interest rates increase, the price of bonds will decrease. The most basic way to measure bond performance is to calculate its yield: Yield = coupon amount / price. So for a $500 par value bond with a maturity date of 10 years and a coupon rate of 5%, its total coupon amount will be $25: 5% yield = $25 coupon value / $500 price. Decrease the price to $400 and the yield increases to 6.25%, increase the bond price to $600 and the yield drops to 4.17%.

Another dynamic to consider when buying bonds is their credit rating. US Government bonds usually carry a lower yield as they carry some of the lowest risk of default and investors are attracted by their security. Bonds with higher yields are often issued by companies and governments with troubled financials in order to attract investors; these bonds are called junk bonds. Credit rating agencies like Standard & Poors and Moody’s allow investors to check the health of bond issuers.

Types of Bonds

As we mentioned before, bonds can be issued by many different entities. US Treasury bonds are issued by the US federal government. This is generally the lowest category of risk and is classified by maturity time:

  • Treasury Bills (T-bill) – Matures in less than a year
  • Treasury Notes – Matures in 1-10 years.
  • Treasury Bonds – Matures in 10 years.

Municipality bonds, or muni bonds are bonds that carry a slightly higher risk but are still unlikely to default, as they are issued by cities and towns: Governments are able to adjust their taxes to pay back bonds. Many muni bonds are also completely tax-free which can be a great incentive for some investors.  Finally corporate bonds are the highest risk category and it’s important to check the credit rating and financials of the company issuing these before considering purchasing.

Zero-coupon bonds should also be of mention.  It’s possible for bonds to be issued without a coupon that is paid annually or semi-annually.  The most well-known kind of zero-coupon bond are Series EE Savings Bonds.  Instead of the Treasury paying coupon rate, these bonds are sold at a 50% discount and accrue interest that can be redeemed along with the par value on or after the maturity date.  There are even some rare bonds on the market which pay a coupon but do not mature.  Finally, it’s possible for the coupons and the par value of bonds to trade separately.

Why Bother With The Bond Market?

The first thing early investors often look to invest in is the stock market, but the bond market is just as important in a balanced portfolio. During a bull market, stocks generally outperform bonds and can deliver staggering returns. However, during a bear market, bonds are often seen as a safe haven to make a predictable return on investment.  Bonds usually perform well when looked at as a long term investment.

Since the fallout from the 2008 financial crisis, the bond markets have been highly active in part due to the fiscal policy adopted by the Federal Reserve.  We’ve reported before that the bond market can also be incredibly risky in this economy. Recent statements by the Federal Reserve chairman have caused the markets to turn and many investors are now exiting on concerns that the Fed will stop quantitative easing and/or raise interest rates.  It’s unlikely that the Fed will be able to keep up its bond purchase programs indefinitely and the bond market could be the next bubble to burst.  Indeed already the US Treasury yields have been on a steady climb.

Where to Purchase Bonds

Most bonds are purchased through a broker. Most brokers require investors to keep a deposit with them in order to purchase bonds on the market.  Be sure if using a broker to background check them at BrokerCheck to be sure of the legitimacy of the broker you’re working with.  The US Treasury also now sells bonds directly through their own Treasury Direct website.  Finally, it’s also possible to trade pools of bonds using various ETF’s to take advantage of leveraging and play on when the yields are going to move.

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