Bonds Explained – How Do They Work & Why Own Them?

Bonds Explained – How Do They Work & Why Own Them?

The investing world boasts a wide variety of financial products, such as annuities, Exchange Traded Funds (ETFs), hedge funds, options and futures contracts.  Underneath nearly all of these complex strategies are two basic building blocks: stocks and bonds.

Many people understand how stocks work.  Stocks give you ownership in a company and the right to share in the company’s bottom line. Stockholders make money with appreciation (growth in the stock price) and dividends (payments from the company’s profits).

Bonds, on the other hand, are less well understood.  How do they work, and why do investors own them?

How do bonds work?

Before we can discuss the “why” of bonds, we must understand the “what”.  A bond is a loan to an issuer, usually a government or company. The issuer will borrow money for a set period of time, ranging from 30 days to 30 years or longer.  In exchange, the issuer pays interest. While bonds can be bought directly from an issuer, most are bought and sold on the secondary market.

How can you make money with bonds?

There are two ways to make money with bonds.  The primary way is interest payments.  In exchange for using your money, the issuer usually sends you regular interest payments. These payments are based on the original amount borrowed (the principal or face amount) and the promised interest rate (the coupon rate).

Some issuers use a fixed rate while others will peg their rate to a certain index, such as the 30-day Treasury bill. Some bonds, called zero-coupon bonds, don’t spin off payments at all.  Instead, they are issued at a discount and will pay out the full face amount on maturity.

The other way you can make money is with price appreciation. The value of your bond may increase because of a number of factors. One is a drop in interest rates.  When market interest rates fall, existing bonds are more attractive with their higher income.

Another reason could be a pullback in the stock market. Because the issuer promises to pay out a fixed rate, regardless of what happens in the economy, bonds are generally considered safer than stocks.  As a result, when the economy starts heading south, investors will sell stocks and buy bonds, pushing up bond prices.

It is important to note that, in the long run, you can’t depend on price appreciation to make a profit.  While the price may go above a bond’s face amount (called “trading at a premium”), the bond will still only pay the original face amount when it matures.

What are the risks of investing in bonds?

While there are many advantages to bonds, they are far from risk-free. They have three risks: credit risk, interest rate risk, and reinvestment risk.

The major risk is credit risk. This is the risk that the issuer can’t make all promised payments. Credit risk varies from issuer to issuer. There is a big difference in the credit quality of “Uncle Sam” who has the authority to print currency versus your uncle Ned’s small start-up in his garage. When selecting bonds for your portfolio, it is imperative that you understand the credit quality before making your purchase.

The next risk is interest rate risk. While a drop in interest rates makes your existing bonds increase in value, a rise in interest rates has the exact opposite effect. While this isn’t a concern if you plan to hold until maturity, it can cause problems if you need to sell sooner than you’d expected.  You may receive less than you originally paid.

The final risk is reinvestment risk. This is the risk that you will have to invest at a lower interest rate when your bond matures or spins off interest payments. This risk is especially great when interest rates are falling. Many bonds are callable, meaning that the issuer can redeem them after a certain period of time. If interest rates have fallen, an issuer may call bonds with higher interest rates to take advantage of the lower market rates.

Why should I hold bonds?

There are many reasons why an investor would want to hold bonds. Many investors hold them for the income. Bonds can provide a steady, regular stream of income on a monthly, quarterly, or semi-annual basis. Many retired individuals appreciate these regular payments.

Second, high-quality bonds provide valuable protection to your stock portfolio. Historically, we’ve seen a negative correlation between stocks and bonds.  This means that when stock prices go down, bond prices go up. In this way, they may act as a natural “hedge” against sharp drops in the stock market.

Finally, many investors use bonds to fund a specific cost.  For example, parents may purchase a zero coupon bond to fund a college education.  Because bonds pay out income based on a regular schedule, they are useful for covering a specified cost.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

There is no assurance that the investment objective of any investment strategy will be attained.

Investment advice offered through Stratos Wealth Partners, Ltd., a registered investment advisor.

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