What Is a Bond? Types, Terminology and Diversification

What Is a Bond

What is a bond? Bonds are a type of debt. They are IOUs or loans. However, here you are the bank. You lend funds to a city, firm or government. In return, they promise to repay the full amount with periodic interest. A municipality might sell bonds for raising funds to build a library. The federal government may issue bonds to fund its growing debt.

Anxious investors often prefer the safety of bonds. Plus, they flock to the steady income stream that bonds produce. This is especially when the share market becomes too unstable. Younger investors must take out a part of their retirement accounts for bonds. Generally, 15% or below. This depends on their goals, age and risk appetite. The aim is to balance out riskier stock investments.

However, this does not imply that bonds are without any risk. Some bonds tend to be very volatile. Like with all investments, you get more for purchasing risky securities. In the world of bonds, such risk comes in different shapes.

The first is the possibility that bond issuer will not default on payment. Fewer sound issuers will pay a higher interest rate. Hence, the riskiest issuers provide “junk” or high-yield bonds. Others having high creditworthiness are investment-grade bonds. The U.S. government issues the safest of the safest bonds. These are called Treasury bonds. They have the backing of the credit and full faith of the government. Hence, they are virtually risk-free. Treasury bonds will give lower yield than investment-grade corporate bonds like Johnson & Johnson. But J&J will not pay interest higher than a bond issued by non-investment grade firm.

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The period for which you hold the bond is also a factor. Bonds with longer timeframe pay higher yields than those short duration. Reason? Because you get paid for locking your money for a longer timeframe.

However, interest rates have the single most significant impact on bond values. As interest rates increase, the bond value falls. Why? Because when rates rise, new bonds are issued at an increased rate. This makes the bonds already existing at lower rates less valuable.

Yes, if you are holding a bond until maturity, then price fluctuations do not matter. Your interest rate was fixed at the time of purchase. So, when the term completes, you will get the face value back. Well, most likely unless the issuer defaults. But, if you sell the bond before its term, you may get less than the initial investment.

Until now, we have discussed individual bonds. Mutual funds investing in bond funds or bonds are slightly distinct. There is no maturity date in bond funds. Hence, both your invested amount and its interest will fluctuate.

Then why even buy a bond fund? You should have substantial funds to create a diverse portfolio of individual bonds. The amount can go up to tens of thousands of dollars. In contrast, bond funds offer instant diversification. The following paragraphs go deeper into the differences between bond funds and bonds.

Types and Terminology of Bonds

Firstly, you should acquaint yourself with the different kinds of bonds and related terminology.

Treasury

The federal government issues them. They are the safest bonds in the market. Yes, you will not get a high interest which you may get elsewhere. But, there is no fear of defaults. Treasury bonds serve as a benchmark to price corporate and muni bonds.

Treasury bonds are available in $1,000 increments. Initially, they are sold through auction. Auctions determine the bond price and interest payment. You can directly make your bidding on TreasuryDirect.gov. This involves no fees. Or you can do it via your broker or bank. These bonds trade like other securities in the open market.

Treasury Bills, or T-Bills

These are short-range investments. They are sold in periods ranging from some days to 26 weeks. T-bills are sold at a discounted price. That is, below their face value, But, when they mature, you get the whole face value. You earn the difference between the face value and the amount you paid. This is the interest you earn.

Treasury Notes

These are issued in terms of 2, 5 and ten years plus increments of $1,000.

Treasury Bonds

Treasury Bonds are issued for 30 years. You get interest on them half-yearly until maturity.

Treasury Inflation-Protected Securities (TIPS)

The purpose of these bonds is to save the portfolio against inflation. TIPS pay an interest rate lower than other Treasury bonds. But their interest payments and principal adjust with the inflation. Keeping TIPS in a tax-deferred account is ideal. For example, an individual retirement account (IRA). You will need to pay federal taxes on the rise in the principal. This is despite you not getting principal back until maturity. Hence, holding TIPS in the IRA is the best. When TIPS mature, investors get either the original principal or the adjusted one. That is, whichever is higher. TIPS are sold for terms like 5, 10 and 20 years.

Savings Bonds

These are the most boring bonds out there. But, it does not hurt to know how they work. You have the option of redeeming savings bonds after one year of holding them. This extends to up to 30 years. Currently, they come in two flavors. The U.S. Treasury issues both these flavors:

EE Savings Bonds 

These bonds earn a fixed interest rate which is presently 3.4%. You can redeem them after one year. However, you do forego three months interest if holding below five years. The maximum period to hold them is 30 years. On redemption, you will get the interest and principal amount. You can buy them as a paper certificate at a bank for half the face value. So, you can buy a $200 bond for $100. Various increments, i.e., $50 to $10,000 are available for this bond. If you buy them online, you get them at face value. However, you can purchase for any amount beginning at $25.

I Savings Bonds 

These are akin to EE savings bonds. However, they are adjusted for inflation half yearly. These bonds always sell at face value. This is irrespective of whether you buy them online or in paper form.

Agency Bonds

They are not as safe as Treasury bonds. However, they are safer than most corporate bonds. Government-aided entities issue them. These enterprises are partly regulated by the government. Hence, they are safer than corporate bonds. However, they do not have the backing of the government’s credit and full-faith. This makes them prone to some risk.

Municipal Bonds, or Munis

Local governments, states, and cities issue these bonds. The aim is to fund different public projects. Munis are not subject to federal taxes. Besides, they may even be exempt from state tax. That is if you reside where they are issued. Some munis are sounder than others. However, some munis have insurance. So, if the issuer defaults, the insurance firm will cover the debt.

Corporate Bonds 

Companies issue these bonds. Corporate debt may vary from highly risky to super safe.

Coupon

This is another term for the interest rate a bond pays. For example, a $2000 bond with a 5% will pay $100 a year. The idea behind using the term coupon is that some bonds do have paper coupons attached. You can redeem them for payment.

Par 

This is a bond’s face value. It is the amount a bondholder gets on bond’s maturity. Suppose the interest rates increase more than the bond’s rate. In this case, the bond will trade below par or at a discount. In contrast, if rates decrease compared to the bond’s rate, it trades above par.

Duration 

This measures the price sensitivity of a bond relative to interest rate changes. It is measured in years. Bonds having longer duration have higher sensitivity to interest rate changes. Suppose, you have a bond of 10 years duration. Now, the interest rate increases by 1%. In this case, your bond’s price will fall by 10%.

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How to Buy Bonds

Bonds are a conventional means of investing in a business, besides stocks. Most financial analysts suggest holding a part of the portfolio in bonds. This is due to their lower volatility. Hence, they are relatively safer than stocks. However, a bond has its own set of risks. So, deciding which bonds to buy and how it can be complicated.

Where to Buy Bonds

Buying bonds are slightly trickier than buying shares. In the case of stocks, investors can start with even little cash. But, bonds can consume a lot of cash to start investing. Most bonds come with a face value of $1,000. There are some options on where you can buy them:

From a Broker

Purchasing bonds from a broker are possible. However, not every broker provides this service. So, you can buy from other investors wanting to sell. Want a discount on the face value? Then, directly purchase the bonds from the underwriting bank.

Exchange-traded Fund

An ETF buys bonds from various firms. Some funds may focus on long-, medium-, and short-term bonds. Others may give exposure to specific sectors. A fund is an excellent choice for individual investors. It offers instant diversification. Plus, you do not need to purchase in thousand-dollar increments.

U.S. Government

The U.S. government runs a program wherein investors can purchase government bonds directly. Investors do not need to pay any fee to the middleman. You can gain access to this program on the website of Treasury Direct.

What to Watch for When Buying Bonds

So, now you know where to buy bonds. The next step is to pick which ones to buy. Not all bonds are the same. Below is a 3-step process to assess bonds. This will help you decide if they suit your portfolio:

Can the Borrower Pay Its Bonds?

This question’s answer is critical. A company should be able to pay back the principal amount and interest. Otherwise, there is no reason to even think of buying them. All you need is some research. You will get a good idea of whether the issuer can repay or not.

Credit Ratings

Three big rating agencies rate bonds. They are Standard & Poor, Moody’s and Fitch. These agencies examine the soundness of the issuers. Then they assign the companies and their bonds credit ratings. The higher the rating, the more the chances of the issuer honoring its obligations. And vice-versa. AAA is the highest rating.

Income Stream

There is one more way to find a company’s soundness. It is by checking how much interest it pays compared to its income. If the firm’s income is not steady and enough, eventually there will be trouble.

So, begin with the firm’s most current year operating income and interest expense. You can easily find these figures in the income statement. Every publicly traded company in the USA, in the 10-K filing, makes this information available. It is present on the firm’s website. You can even look at the EDGAR database on the Securities and Exchange Commission’s (SEC) website. Operating income and net income are two different concepts. It is because operating income does not include taxes and interests. Hence, it is the ideal measure of a firm’s capacity to pay debt obligations.

On the 10-K, locate the firm’s yearly operating income. Then divide it by the interest expense. This is how you should infer the result:

4 or higher: The firm will easily meet its debt obligations.

2.5 to 4: Here, the firm might be in decent shape. However, it is at the lower side of the range. Hence, a closer look is needed.

1 to 2.5: The firm may face some trouble if business worsens.

Below 1: This company will inevitably face troubles in paying debt obligations.

Check the consistency of these results. For this, compute the results for earlier years too. It is likely that one bad or good term can throw off outcomes. Plus, you will need a broader image to make decisions.

Evaluating Government Bonds

This can be a little trickier. Why? Because governments do not have massive surplus revenues which signify stability. Still, government bonds are the safest. U.S. government issued bonds are the safest in the world. They have an AAA rating. They are so safe that the government’s interest rate is called “risk-free rate.”

Evaluating Municipal Bonds

Municipal bonds have historically been safe. However, they are not as rock-solid as federal government bonds. You can sleuth these bonds on the Electronic Municipal Market Access (EMMA) website. A bond’s official prospectus is present here. Plus, it also furnishes the audited financial records of the issuer. All the ongoing disclosures like defaults and delinquencies are also there. The credit rating of a government is the 1st guide to its soundness. You can follow up to check if in recent past there was any default.

Is Now the Right Time to Buy Bonds?

The bonds trade in the debt market. This is once, their interest rates are set, and they are available to investors. Then the shifts in existing interest rates determine how the bond’s price varies.

Bond prices move anti-clockwise. As the economy swells, interest rates increase. This reduces bond prices. In contrast, when the economy falls, interest rates decline too. This increases bond prices. One may think that the best time to buy bonds is during a boom. That is when bond prices are low. And vice-versa for selling them. However, it is not that easy.

Besides this cyclical shifts, interest-rates also undergo long-run changes. For instance, interest rates in the US have tended to decline since 1980. This is despite their continual up and downshifts during economic cycles. Hence, interest rates have undergone lower cyclical lows and highs. However, the future may be different. It may see a trend of growing rates rather than declining ones.

Bond investors always wonder if rates will fall or rise. But, waiting for bond purchases may amount to attempting to time the market. Such, market timing is a strict no-no for amateur investors.

To handle this uncertainty, most investors ladder their exposure. Investors purchase several bonds with varying maturities. As one bond matures, they reinvest the principal. This is how the ladder grows. Laddering helps in diversifying interest-rate risk. However, this comes at the expense of low-yield.

Which Bonds Are Right for My Portfolio?

Entities like federal/state government, cities and companies issue bonds. The kind of bond suitable for you depends on many factors. This includes your risk appetite, tax situation, and income needs.

Below is a sampling of some leading types of bonds. It goes from low-risk to riskiest.

Federal Government Bonds

Bonds, which the federal government issues, are the safest. They are so safe that their interest rate is termed “risk-free rate.” Plus, it is very low. The government even issues “zero coupon bonds.” It sells them below par. Besides, you can redeem them at face value when they mature. However, you do not get any cash interest.

Municipal Bonds, or Munis

The local and state governments issue these bonds. They are the lowest-yielding bonds. However, they make up for this drawback by being non-taxable. Their after-tax yield may be higher than other high-yield bonds. This is especially true for investors from high-tax places.

Investment-Grade Corporate Bonds

Companies issue these bonds. These companies have decent to excellent credit ratings. As they are safer issuers, their interest rate is lower than low-rated bonds. However, the interest is still higher than what the federal government pays.

High-Yield Bonds

People also know them as junk bonds. These bonds provide a bigger payout. Sometimes it is even higher than common investment-grade bonds. This is because of their highly risky nature.

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Diversifying a Bond Portfolio

A sound bond allocation may have bits of every type. This diversifies the portfolio and reduces principal risk. Investors may even stagger the maturities for reducing interest-rate risk.

Diversification of a bond portfolio could be more stringent than a stock portfolio. Bonds are typically sold in $1,000 increments. Hence, it requires too much cash to create a diverse bond portfolio.

To resolve this, it is easier to buy ETFs focused on bonds. They offer diversified exposure to the bonds you want. Plus, you can assemble various bond ETFs even if you do not have too much money. It is very crucial to find a low-cost fund. This is because interest rates have been quite low since the recession.

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