What is a Bond? A bond is an IOU between the lender and the
borrower. The issuer of the bond is the borrower and the lender is the person who purchases the bond – the investor.
The three basic components of a bond are its maturity, its face value, and its coupon (interest) rate. In the simplest example, the borrower would issue bonds in denominations of $10,000 at a
5% interest rate, maturing in 20 years. The borrower- the issuer - pays the purchaser of the bond $500 in each of the 20 years they own the bond. This is the fixed income component of bonds. In addition, the lender – the investor - receives back the original $10,000 purchase price or face value at the end of the 20 years. This capital preservation is a big plus to investors who do not want to risk losing capital in the equities markets.
Different entities will issue bonds to raise cash. The most well-known bond issuer is the US Treasury. (This includes the well-known savings bonds that we often buy for new grandchildren.)
Many government agencies and municipalities will issue bonds either for a specific purpose or as general obligation. Earnings on Government bonds will have different tax statuses. The interest paid to the investor on bonds issued by the US Treasury cannot be taxed by state or local governments but it is federally taxable. A Pennsylvania resident who purchases a PA Bond will not pay taxes on the earnings in Pennsylvania either. But, move to New Jersey and they will start paying taxes on the interest earned from the PA Bond.
Corporations also issue bonds. When a company needs to raise money for investment or expansion, they can issue new shares of stock or they can issue bonds. The advantage to the company – the borrower – is that the company does not have to give up any more control through the issuance of additional shares of stock.
Another advantage to the company is that the interest they pay on the bonds is tax-deductible, meaning that the corporate tax burden is reduced. Dividends on stocks are paid out of after-tax earnings. In the event the issuing corporation goes bankrupt, bondholders would be paid first. Stockholders get what is left over, if anything.
Bonds are considered a very conservative investment, great for those nearing or in retirement when a steady, fixed income is needed. One of the best parts of holding a bond is the fixed
interest payment that you receive yearly.
The maturity date of a bond is the date when the principal is returned to the investor and the company’s obligation to pay for the use of the capital ends. Maturity is one of the primary considerations an investor weighs against their investment goals and time horizon. Bonds are classified as either short-term, maturing within three years; medium-term; or long term, maturity dates longer than ten years.
But what if you need to cash your bond now instead of holding it to maturity? There are secondary markets where bonds are traded. In fact, these secondary bond markets are larger than the stock market in terms of value.
The risk in the secondary market is that one might receive less than the face value paid to purchase the bond. You often hear in the media that bond prices vary inversely with market interest rates. If current market rates are higher than the fixed amount that the bondholder is earning, a new investor will want to pay less than the face value of the bond. Otherwise, they could purchase a new bond at today’s interest rates. If high inflation is on the horizon, market interest rates will rise and bond values will fall.
Another factor affecting the market value of a bond is the uncertainty around whether the issuer will make the promised payments. In the primary market, the issuer would be forced to offer a higher interest rate to entice buyers to lend them money. Higher uncertainty equals higher risk and calls for a higher return for the investor.
Bonds are a good way to strengthen the risk-return profile of your portfolio. Bonds add todiversification and reduce volatility. Hopefully, the above explanation will reduce the complexity of bonds in your mind.
There are a number of ways to buy bonds, from purchasing individual bonds either in the primary or secondary markets to buying bond mutual funds.
Bond mutual funds are the easiest way for the individual investor to enter the bond market. The funds own large, well-diversified fixed income portfolios, allowing the investor to hold wide variety of fixed income securities. A well-diversified bond fund holds different maturity dates, interest rates and credit quality. This is known as bond laddering which reduces interest rate risk. Bond laddering also provides flexibility, reduces the amount of capital tied up for long periods and allows the fund or individual bondholder to adjust bond holdings as market conditions change.
Bond mutual funds are an easy way to diversify your portfolio without needing a large sum of money. Investors of any age seeking a consistent income stream in a diversified portfolio would be wise to consider bond funds although they are generally considered to be conservative investments.
This is not to say that there is no risk involved in a bond fund. “An investor in a bond fund has no guarantee they’ll recover their principal at a future point in time, especially in a rising interest rate environment where the overall value of the bond fund can decline,” says Bryan M. Kuderna, an economist and podcast presenter.
Before diving into the bond market, whether through individual purchases or through bond mutual funds, it is wise to consult with your financial advisor. I can help you to decide whether
investing in bonds is right for you.
Not all bond funds are created equal. I can guide you to investing in the bonds or funds that are right for you.
Please feel free to call (215-836-4880) or email the office (ellend@regardingyourmoney.com) to set up an appointment to discuss any investment questions you may have. Or, visit us at
regardingyourmoney.com.
Sources: Forbes Advisor, Investopedia, Clifford W. Smith @ Simon Graduate School of Business