The Basics of Bonds

Bonds represent the debts of issuers, such as companies or governments. These debts are sliced up and sold to investors in smaller units. For example, a $1 million debt issue may be allocated to one-thousand $1,000 bonds. In general, bonds are considered to be more conservative investments than stocks, and are more senior to stocks if an issuer declares bankruptcy. Bonds also typically pay regular interest payments to investors, and return the full principal loaned when the bond matures. As a result, bond prices vary inversely with interest rates, falling when rates go up and vice-versa.

The bond markets are a very liquid and active, but can take second seat to stocks for many retail or part-time investors. The bond markets are often reserved for professional investors, pension and hedge funds, and financial advisors, but that doesn't mean that part-time investors should steer clear of bonds. In fact, bonds play an increasingly important part in your portfolio as you age and, because of that, learning about them now makes good financial sense. In fact having a diversified portfolio of stocks and bonds is advisable for investors of all ages and risk tolerance.

What Is a Bond?

When you purchase a stock, you're buying a microscopic stake in the company. It's yours and you get to share in the growth and also in the loss. On the other hand, a bond is a type of loan. When a company needs funds for any number of reasons, they may issue a bond to finance that loan. Much like a home mortgage, they ask for a certain amount of money for a fixed period of time. When that time is up, the company repays the bond in full. During that time the company pays the investor a set amount of interest, called the coupon, on set dates (often quarterly).

The main types of bonds are:

1. Government
2. Corporate
3. Municipal
4. Mortgage
5. Treasury

Government bonds are generally the safest, while some corporate bonds are considered the most risky of the commonly known bond types.

For investors, the biggest risks are credit risk and interest rate risk. Since bonds are debts, if the issuer fails to pay back their debt, the bond can default. As a result, the riskier the issuer, the higher the interest rate will be demanded on the bond (and the greater the cost to the borrower). Also, since bonds vary in price opposite interest rates, if rates rise bond values fall.

Credit Ratings

Bonds are rated by popular agencies like Standard and Poor's, and Moody's. Each agency has slightly different ratings scales, but the highest rating is AAA and the lowest rating is C or D, depending on the agency. The top four ratings are considered safe or investment grade, while anything below BBB for S&P and Baa3 for Moody's is considered "high yield" or "junk" bonds.

Although larger institutions are often permitted to purchase only investment grade bonds, high yield or junk bonds have a place in an investor's portfolio as well, but may require more sophisticated guidance. Generally, governments have higher credit ratings than companies, and so government debts are less risky and carry lower interest rates.

Pricing Bonds

Bonds are generally priced at a face value (also called par) of $1,000 per bond, but once the bond hits the open market, the asking price can be priced lower than the face value, called a discount, or higher than the face value, called premium. If a bond is priced at a premium, the investor will receive a lower coupon yield, because they paid more for the bond. If it's priced at a discount, the investor will receive a higher coupon yield, because they paid less than the face value.

Bond prices tend to be less volatile than stocks and they often responds more to interest rate changes than other market conditions. This is why investors looking for safety and income often prefer bonds over stocks as they get closer to retirement. A bond's duration is its price sensitivity to changes in interest rates—as interest rates rise bond prices fall, and vice-versa. Duration can be calculated on a single bond or for an entire portfolio of bonds.

Bonds and Taxes

Because bonds pay a steady interest stream, called the coupon, owners of bonds have to pay regular income taxes on the funds received. For this reason, bonds are best kept in a tax sheltered account, like an IRA, to gain tax advantages not present in a standard brokerage account.

If you purchased a bond at a discount, you'll be required to pay capital gains tax on the difference between the price you paid and the bond's par value, normally $1,000 per bond, but not until the bond matures and you receive the face value of the bond.

Issuers of bonds, on the other hand, such as corporations, often receive favorable tax treatment on interest, which they can deduct from their taxes owed.

Local governments and municipalities may issue debt too, known as municipal bonds. These bonds are attractive to some investors as the interest payments to investors can be tax-free at the local, state, and/or federal level.

Issuers of Bonds

There are four primary categories of bond issuers in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms.

• Corporate bonds are issued by companies. Companies issue bonds—rather than seek bank loans for debt financing in many cases—because bond markets offer more favorable terms and lower interest rates.
• Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.
• Government (sovereign) bonds such as those issued by the U.S. Treasury. Bonds (T-bonds) issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1 to 10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury is often collectively referred to as "treasuries." Government bonds issued by national governments may be referred to as sovereign debt. Governments may also offer inflation-protected bonds (e.g. TIPS) as well as small denomination savings bonds for ordinary investors,
• Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.

How to Buy Bonds

Most bonds are still traded over the counter (OTC) through electronic markets. For individual investors, many brokers charge larger commissions for bonds, since the market isn't as liquid and still requires calling bond desks in many buy and sell scenarios. Other times, a broker-dealer may have certain bonds in their inventory and may sell to their investors directly from their inventory.

You can often purchase bonds through your broker's website or call with the bond's unique ID number, called the CUSIP number, to get a quote and place a "buy" or "sell" order.

Alternatives to Buying Bonds Directly

If you want the income earning power of a bond, but you don't have the funds or don't want to own individual bonds, consider a bond ETF or bond mutual funds. These are well diversified funds that give you exposure to many different bonds, and pay a monthly or quarterly dividend.

Because some bonds have a minimum purchase amount, smaller investors may find these products more appropriate for their smaller amount of capital, while remaining properly diversified.

The Bottom Line

Most investors, regardless of age, should have at least a small amount of their portfolio allocated to fixed income products such as bonds. Bonds add safety and consistency to a portfolio. Although there is a risk that a company may default and cause a large loss, investment grade bonds rarely default. However, along with this safety comes a lower rate of return.