The Ultimate How Bonds Work Guide

The Ultimate How Bonds Work Guide

Bonds confuse lots of people but actually they are very straight forward. When you buy a bond you loan your money to a company, city, state or country for a fixed term. When you first make the loan, the interest rate is fixed (in most cases) as is the maturity date (the date they have to repay you).

During the period of the loan, you usually receive interest every 6 months. In the vast majority of cases, the interest payment you receive never fluctuates; you always get the same payment regardless of what happens in the stock market and regardless of what happens to interest rates. When the term is up, you (hopefully) get your money back.

What happens if you need to cash in your bonds before they mature?
When you buy a bond, the company or government that borrows the money is only obligated to pay you interest every 6 months and to repay the face amount of the bond when it matures. If you need to cash the bond in before it matures, you must sell it to somebody else.

If you do that you may get more or less than you put in, depending on market interest rates, the general state of affairs in the economy and the specific situation the borrower is in. In other words, the value of your bond goes up and down all the time.

This doesn’t matter if you hold your bond to maturity because at that point, the borrower has to give you back the face amount (assuming they are able to do so).

Bond Terminology
Before we dive too deep into the world of bonds, let’s go through a little terminology. It’s not that complicated and it will really help you get a grasp of what’s going on.

Accrued Interest.

Bonds pay interest every 6 months. This period is fixed. As soon as the bond pays out interest, it starts accumulating interest for the owner the next day. This is known as the accrual period.

Let’s say you buy a bond that normally pays interest to the bond holders on January 1st and July 1st. If you buy that bond on June 1st for example, you’ll get all six month’s interest on July 1st even though you only owned it for 1 month. To make up for that, when you buy a bond in between payout dates, the buyer pays the seller for the number of days the seller held the bond after the last payout. That’s called accrued interest. If you buy a bond in between pay dates, you can confirm the accrued interest the seller is charging you by using any number of online calculators.

In this case, you’d owe the seller of the bond for 5 months of interest and you’d have to pay the seller that accrued interest in addition to the amount you pay for the bonds. That amount would be rolled into the price of the bonds when you buy them.

Call Date

Sometimes, the borrower (or issuer) has the right to repay their loan earlier than the maturity date. This is otherwise known as calling the bonds early. When you buy a bond, it’s always important to ask if the bonds are callable and if so, at what date and price. (Sometimes the call price is different than the face amount of the bond.)

Coupon Payment

This is the amount the bond holder will receive every 6 months. You calculate this by multiplying the interest by the face value of the bond.

CUSIP

The American Bankers Association developed a way to classify municipal, corporate and U.S. government bonds. What they came up with is known as a “CUSIP number” which is a unique nine digit alphanumeric identifier.

Discountbond funds

If you buy a bond at less than face value, the difference is a discount.

Duration

The length of years before the bond matures.

Face Amount

This is the par value of the bond. It is the amount that the borrower must pay the bond holder when the bond comes due.

High Yield Bonds

These are bonds that pay higher than market interest rates and they are otherwise known as junk bonds. Usually these bonds pay higher rates because the risk of default is higher. The added interest is meant to compensate the investor for this added risk.

Investment Grade Bond

There are rating agencies that evaluate how secure different bonds are. In other words, the higher the rating, the stronger this rating agency believes the bond issuer is and their ability to pay interest and principal. This in turn means that rating agency believes that the bond is appropriate for investors seeking preservation of capital.

Issuer

This is the name of the party that borrows the money by issuing the bonds.

Liquidity

This is an estimation of how easy or difficult it will be to sell the bonds on the secondary market. If the bonds are in high demand, it will be easy to sell them if the need arises. If the bonds are not in high demand or there are very few bonds being traded, they are referred to as “non-liquid”. Investors who hold illiquid bonds may have to offer them at a steep discount if they want to sell them prior to maturity.

Maturity Date

This is the date when the issuer must repay all bond holders the face amount of the bonds plus the accumulated interest since the last interest payment date.

Nominal Interest

This is the fixed interest rate that the bond issuer pays to the bond holder.

Payment Date

This is the date that the issuer pays out to registered owners of the bond.

Premium

If the market price of a bond is higher than the face value, buyers pay a premium.

Principal

This is the face amount of the bond.

Yield

This is the return the investor earns based on the actual amount they invest.

Why Bonds Fluctuate In Value Prior To Maturity
The best way to understand this is to look at an example. Let’s assume you buy a $100,000 bond with a 5% interest rate at par value. In this case, you will receive $2500 twice a year for a total of $5000. No matter what happens in the market, as long as the people who issued the bond have the ability to pay, that’s how much you will get. No more. No less.

Now, let’s assume that a couple of years go by and interest rates go up to 10%. If you try to sell your $100,000 bond on the secondary market, you won’t get $100,000 for it. Here’s why.

If I have $100,000 to invest when rates are 10% and I buy bonds, I’ll receive $10,000 a year in interest. So if your bond is only paying $5000 a year, I know I only have to invest $50,000 to earn that $5,000 (because interest rates are now 10%).

That being the case, since your bond is paying a fixed $5000, the most I’ll pay you for your bond when interest rates rise to 10% is $50,000. Make sense? This is why as rates go up, the value of the bonds typically go down.

All investments are ultimately valued by the income they generate; either now or in the future. Remember that. It will help you understand how other investments operate as well.

Of course, the other side of this equation also works. Let’s say rates go down to 2 ½ % rather than go up. Are you going to sell me your bond that pays $5,000 a year for $100,000? No. That’s because, when rates are 2 ½%, someone would have to invest $200,000 in order to replicate the $5000 income your bond is paying you. So if somebody wants to buy your bond when rates drop to 2 ½%, they better be willing to cough up $200,000 or you won’t sell.

Other Factors That Move Bond Prices
Besides market interest rates, there are other economic pressures that impact bond prices. One major influence is the financial security of the issuer. If the company that issued the bonds is on the ropes and nobody expects them to be around when it’s time to pay back the bond holders, the value of those bonds will plummet.

In addition, if the economic conditions of the overall economy change for the better or worse, that could also impact the value of the bonds. That’s because if the open market expects interest rates to shift, bond values will shift along with them.

Another force that impacts bond values is the time to maturity. The longer the maturity, the greater the impact of the changes outlined above – all things being equal.

What happens when a bond matures?
When your bond matures, the borrower (or issuer) stops paying interest and you are supposed to get your money back. In order to understand how you get your principal back, you first have to understand how people actually hold their bond investments.

In the vast majority of cases, people hold their bonds in brokerage accounts. That means they don’t have a physical certificate but merely an electronic notation in their statements reflecting their ownership. This may not sound that secure but in reality, this is by far the safest way to hold bonds.

When a bond comes due in this case, the brokerage company simply removes the bond from the holdings and puts the cash redemption amount into the account. Very easy.

But some investors hold physical certificates instead. In the olden days, this was the only way you could hold bonds; to get a physical piece of paper and store it somewhere safe. And while most people don’t have to bother with this today, some still prefer to do so. For these people, the process of redeeming a bond is more complicated.

If you hold the physical bond certificate and it matures, you send the paper certificate to what’s called the transfer agent when the bond matures. This agent is a fiduciary intermediary that acts as an agent for both you and the bond issuer. When the bond comes due, the transfer agent will get your certificate from you and send it to the issuer. Then, the issuer will send the redemption value to the transfer agent who in turn puts the money in your account.

The idea of holding the certificates may sound appealing to you but there are downsides to this approach. First, if a bond matures and you hold the certificate, the agent or issuer may not reach out to you. It may be up to you to follow up with them. When your bonds are held by the brokerage firm, you don’t have that worry.

Another concern is that bonds held in certificate form can be lost or destroyed. If you happen to misplace your bond, you may have to pay 3% of the face value or more in order to get it replaced.

Bottom line? If you own bonds, chances are you will be far better off by depositing them with a broker.

TYPES OF BONDS
All bonds are debt instruments because they represent a debt that someone has to the bond holder. There are many different types of debt instruments and each kind has its own benefits and risk profile.

The most prolific debentures are U.S. government notes, bills and bonds. These are all issued by the United States Department of the Treasury. These are all very liquid and are very easy to sell on the secondary market.

Treasury bills are debts that mature in one year or less. The interest is included in the price you pay for the bill. That means you pay less than the face amount of the bond when you purchase them. And when it matures, you will receive the full face amount. The difference is the interest and this is an example of buying bonds at a discount.

Treasury notes are issued for 2 to 10 years. These bonds pay interest semi-annually.
Treasury bonds are the longest maturity U.S. government debt you can buy. They are issued for 20 to 30 years.

The government also sells inflation protected bonds called “TIPS”. This is an acronym for “Treasury Inflation-Protected Securities”. You may recall that with typical bonds, the maturity value and interest payments are fixed while the value of the bond fluctuates prior to maturity.

With TIPS, the rate stays the same but the maturity value is adjusted by the Treasury department to compensate the bond holder for risk. If rates rise (CPI) the maturity value of the bonds rises as well. This way, if inflation gets out of control, TIPS investors have a built-in safety net.

Currently, TIPS investors receive interest every 6 months and can buy bonds that mature over 5,10 or 30 years.

While these bonds may sound attractive for those worried about inflation, you might want to hold on to your check book for a while. I say this because nobody knows which way rates are going and how long it will take them to get there. If rates are low and stay down for years, it might take a long time before your TIPS prove themselves as worthwhile investments.

The government bonds discussed above all provide interest that is taxable at the Federal level, but State tax free.

Municipal Bonds
Besides U.S. government bonds, you can also loan your money out to cities, and states. These are referred to as municipal bonds and when you buy these bonds, the interest you receive is Federal tax-free. And in many cases, the interest you earn is also State tax free. The reason the interest is tax free is to make these investments more appealing to investors while making the borrowing costs lower for the cities and state.

The value of the bonds fluctuate and are subject to the same risks as discussed above.

Other Types Of Bonds
You can loan your money out to different countries or private companies as well. The same risks apply to these investments without the tax benefits described above. When you loan money to another country, the backing is only as secure as the country itself.

The history books are full of cases where sovereign nations defaulted on their bonds and left bond holders high and dry. Because of these risks, some foreign nations have to pay higher rates in order to attract investors. Of course, this depends on the financial stability of the borrower at the time they seek out funds.

You can also lend money to corporations here and overseas. Again, these bonds work the same way I’ve described above. And like foreign national bonds, the interest earned and the investment safety are very much a function of the particular party you are considering lending money to.

What happens if the borrower doesn’t repay you?
If the company, city, state or country that borrowed money from you does not have the wherewithal to pay you the interest or the principal they owe, you probably won’t be a very happy camper.

When this happens it’s known as default and it’s usually ugly. When the issuer is a company, they usually file for bankruptcy before they default. If they don’t, the bond holders usually force bankruptcy on the company.

If the company goes into a Chapter 7 bankruptcy, the court takes over the business and its assets are sold off. If your bonds are secured by assets, you’ll be among the first to see some money. If your bonds are unsecured, you won’t see a dime until the secured creditors are taken care of.

Chapter 11 bankruptcy puts the court in charge of the company but assets are not sold off. The hope here is that debt holders will get more if the company continues to operate rather than be sold off.

In either case, bond holders usually lose money when the issuer goes into bankruptcy and the value of their bonds will likely whither.

Municipalities can go bankrupt too but that doesn’t happen often. That’s because it’s very difficult for a municipal government to do so. In fact, there have been fewer than 500 municipal bankruptcies over the last 60 years compared to tens of thousands of business bankruptcies filed each year.

In the rare case where a city does file bankruptcy and defaults on its debt, the recovery rates were about 62% according to Moody’s Investor Services. To give you something to compare this too, corporate bond holders of defaulted securities usually recovered only 49% on average between that same period 1970 to 2012.

What about bond funds?
There are many ways you can invest in bonds. You can buy individual bonds of course as I described above. But you can also use mutual funds and/or ETFs to buy bonds. There are pros and cons to each. Let’s take a closer look at bond mutual funds, ETFs and index funds).

When you invest in a bond fund, the fund managers buy……ahhhhh……bonds. No surprise there.
But there are big differences between buying a bond outright and buying them through funds or ETFs. When you own a fund for example, you incur fund expenses. Some bond funds are expensive and others are very inexpensive. (We’ll look at fund expenses later on in the guide.)

On top of that, funds don’t have maturity dates – individual bonds do. The fund is a pool of potentially hundreds of different bonds and each one comes due at a different time. When one bond matures, the fund managers will in most cases immediately turn around and reinvest the proceeds into a different bond. Because there is no maturity date with a bond fund, you never have a fixed date when anyone is forced to repay your money.

Also, with an individual bond, you know what interest you are going to receive and when. With a bond fund, it’s not that simple. Remember, there are hundreds (sometimes thousands) of bonds that make up the fund. They all have different rates and different pay dates. While the income won’t change that much in any one month, it will change over time as old bonds mature and new bonds (at different rates) are purchased.

(Bond funds themselves come in a variety of different stripes. You can buy muni bond funds, international corporate or sovereign bond funds, and corporate bond funds. The holdings of each fund is determined by the fund prospectus. This is the document that details what the fund managers can and can’t do. Typically, the prospectus spells out what kind of bonds the fund will purchase, what quality the bonds will be and what the duration of the bonds would be as well.)

So these are two downsides to owning bond funds. But there are also some strong positives.

First and foremost, a bond fund spreads your risk. If you put all your money into one bond, you could lose it all if the bond defaults. With a bond fund, no one bond default can hurt you that much. Also, with a bond fund you have expert managers at the helm. All they do is read prospectuses and check out the financial strength of potential bond issuers all day long. These people have more expertise and time than you have and they are better equipped to keep your money away from shaky deals. This is not to say that they are always successful. But they do have better tools and resources than you do.

Also, you can put any amount you want into a bond fund. That’s not the case with individual bonds. Typically individual bonds are sold in increments of $100,000. That’s a lot of scratch for most people. If you buy individual bonds you need to invest several million dollars in order to have a diversified portfolio. With bond funds, you have access to wider diversification with only a $100 investment.

Last, with bond funds, you usually don’t have to worry about liquidity. If you own an individual bond and want to sell it before it matures you have to sell it on the open market and hope for the best. That involves commissions of course but it also involves risk. And if the bond you want to sell is a small issue and illiquid, it may take time to sell. To make matters worse, illiquid bonds are often sold at steep discounts as I mentioned before. If that’s the case, you could take a major haircut on your principal if you need to bail out of an individual bond prior to maturity.

This isn’t a problem for bond fund investors because the fund has more liquidity. Keep in mind that on any given day investors are buying and selling shares of the fund. Often, a fund manager can use the cash inflow to pay off those people who want to cash out. Often they can do this without even selling off any bonds.

Also, as the market shifts, bond holders can easily shift with it. For example, if you decide you want to sell your corporate bond fund and buy a municipal bond fund (or any other fund) instead, it’s very easy and inexpensive to do. The same can’t be said for investors who own individual bonds as this process is much more costly for them.

How to buy bonds and bond funds
Most people who buy individual bonds do so through their broker. The one tricky thing about this is that sometimes you don’t know how much commission they are charging. For some reason, it’s actually legal for a bond broker to “bury” the commission into the cost of the bond so the customers don’t know what they are paying.

For example, lets’ say you want to buy a bond. You call up your broker and tell her what you are looking for and she comes back to you with an offer of XYZ bond paying 4% maturing in 2030.

Let’s say you like the sound of that so you give your broker the green light and she buys the bond at par value – $100. This could be OK – but you don’t know for sure. It could very well be that the broker only paid $97 for the bond and is charging you over 3% to make the transaction. This is referred to as “mark up”. It’s a cost that is often difficult to ascertain because it’s buried into the price of the bond. This might be OK in someone’s world but it’s not OK in mine.

There are calls in the industry for brokers to fully disclose markups but so far this requirement has not been put in place. The best thing to do is ask your broker what the mark up is and hope they are being honest. Once you get that information, check with another broker to determine what price they would charge for the same bond – and tell your existing broker you are going to do so. Very few people do this but it’s the only way you can audit your broker under current rules and is very much worth the time.

If you want to buy Treasuries, you can sidestep this entire problem and buy them directly from the Federal government.
All you have to do is go to their website (Treasury Direct) and have at it. If you do, you won’t have to worry about commissions and mark ups as there are none. There are some costs to this but they are relatively minor and nothing to worry about.

On your first visit, you’ll have to open an account – but that only takes about 10 minutes. Once you do that, you can buy Treasury Bills, Notes, bonds or TIPS.

The easiest way to buy mutual funds or ETFs is to do so through a broker. Don’t buy funds at a mutual fund company however. If you go that route, you can only buy funds offered by that particular fund family. If you buy your funds through a brokerage firm like TD Ameritrade, Fidelity or E*TRADE, you can buy almost any fund you like. I’ll discuss this in further detail later on.

Bottom line on Bonds
Bonds are very popular – but that doesn’t mean they are the right investment for you. It depends on your investment objectives. Please refer back to the Ultimate Investment Guide for a deeper discussion on this point. Bonds may have a place in your portfolio. And if they do, this guide has explained most of what you need to know in order to make smart decisions about bonds. As always, speak to your investment professional before making investment decisions.

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