Strengthening Your Financial Toolbox Series: What is A Bond?
Many people are looking for ways to increase their financial literacy, but it can be overwhelming knowing where to start. In our experience, investors with some degree of familiarity with basic investment concepts have better long-term results and reduced anxiety when the markets are volatile. We like to look at significant investment categories like tools in a toolbox. You first need to understand your financial planning goals to know which tools to select for the job. In our toolbox series, we will cover several of the investment tools available and highlight what role they may play in your financial plan. As you know from DYI projects at your home, having the right tool can make the job go much smoother. The second investment tool we will be covering in our toolbox series is a bond, so let's jump right in.
What is a Bond?
Bonds are investment securities where an investor lends money to a company or a government for a set period in exchange for regular interest payments. Another way to think of a bond is as an "I Owe You" between the purchaser of the bond and the company.
Who Issues Bonds?
The most common issuers of bonds include companies, municipalities, and states or federal governments. Various local levels of governments use bonds to fund projects such as roads, schools, dams, or other infrastructure. Similarly, corporations will often borrow to grow their business, buy property and equipment, undertake profitable projects, or hire employees.
How do Bonds Work?
The first stage of a bond's life starts at the bond origination when a company issues a bond. Next, those bonds can be purchased by investors. Most corporate and government bonds are publicly traded; however, others are traded only over the counter or privately, limiting who may purchase a specific bond. After a bond has been purchased, investors receive their regular interest payments from the bond's issuer until the date of maturity. These are known as "coupon payments." A coupon payment is determined by the coupon rate, which is a percentage of the principal. Lastly, when the bond matures, the bond's issuer repays the principal to the investor.
After reading that life cycle, you may be wondering how the bond's market price is determined. Well, the actual market price of a bond depends on many different factors. A bond's price changes daily, just like that of any other publicly traded security. Factors such as supply and demand, the issuer's credit quality, the length of time until expiration, and the coupon rate compared to the general interest rate can play a significant role in determining the market price.
Another critical point to note regarding bonds is that the initial bondholder can sell most bonds to other investors after they have been issued. In other words, a bond investor does not have to hold a bond through to its maturity date. However, if you sell before the bond maturity, the price you receive is set by the market and you may receive more or less than if held to maturity. Lastly, it is also common for bonds to be repurchased or redeemed by the borrower if interest rates decline or if the borrower's credit has improved, and they can reissue new bonds at a lower cost.
Example of a Bond
One of the best ways to learn about a tool is through real examples, where we get to see step by step how something works. Below we'll walk through an example of how a bond works throughout its life cycle.
1. Company Y issues you a 10-year bond with a face value of $10,000 and a coupon rate of 5%.
2. You agree to buy that bond under the conditions that the company will pay you $500 each year in interest over ten years.
3. When the end of the 10 years is up, the company will repay your initial $10,000, plus you will have acquired $5,000 in total interest payments over those 10 years.
How Bonds are Rated
Just as we are given a credit report and rating, so are bond issuers and their bonds. Credit ratings for a company and its bonds are commonly completed by credit rating agencies such as Standard and Poor's, Moody's, and Fitch Ratings. The highest quality bonds are given the title of "investment grade," these tend to include bonds from organizations such as the U.S. government and very stable companies. Bonds on the other end of the spectrum are known as "high yield" or "junk" bonds. These bonds come with a higher risk for the investor, and often a higher interest payment is given to compensate investors for that risk.
5 Types of Bonds Explained
There are many different varieties of bonds available to an investor. Bonds may vary based on their seller, purpose, buyer, level of risk and return, and so much more. Here are five types of bonds you may frequently come across:
• Treasury/Government Bonds: Treasury or government bonds are issued by the federal government to fund government spending. These bonds are used to fund deficits in the federal budget, and they help raise capital for various government projects. Treasury/government bonds are usually exempt from state and local taxes, but they may still be subject to federal taxation. Furthermore, they are often considered the safest bonds to invest in because the federal government backs them.
• Agency Bonds: An agency bond is sold by a government-sponsored enterprise or a federal government agency other than the treasury. Examples of such agencies include Fannie Mae and Freddie Mac. The federal government fully guarantees some agency bonds, but others are not fully backed.
• Municipal Bonds: Municipal bonds are typically issued by state, municipality, or county governments to finance expenditures. Such finance projects can include things like roads or schools. These bonds usually have a higher interest rate than government bonds and are often exempt from federal, state, and local taxes. However, they are a bit riskier than bonds issued by the federal government due to the occasional default.
• Corporate Bonds: A corporate bond is a bond issued by a company and sold to investors to raise capital for various reasons. Companies may use the money they raise from issuing bonds to further their operations, hire new employees, increase research and development, and much more. Bonds provide a solution to companies as many of their projects require more money than banks and other lenders can provide. One important point to note is that a corporate bond is typically considered to have a higher risk for investors, but they usually offer a higher rate of return.
• Savings Bonds: Savings bonds are another type of bond issued by the federal government's treasury department. Savings bonds are typically meant to be purchased by individual investors as they are usually issued in low amounts to make them affordable. Some unique features to remember about savings bonds is that they usually earn monthly interest that is compounded semiannually, they typically cannot be bought and sold between private parties, and they generally do not have to be held to maturity.
How Do You Buy a Bond?
Most individual bond buyers will buy or sell them using the services of a broker. Sometimes bonds can be purchased directly from an issuer, such as with various government bonds. It is important to understand the specific details of the bond you are purchasing. Many bond issuers have different series of bond trading and they most likely have different investment features. The bond market is much larger than the stock market, but many of the bond issues are thinly traded making it more difficult to determine the market value of the specific bond.
Schedule A Consultation with an Experienced Financial Advisor
Here at Fourth Avenue Financial, our first priority is your overall financial success. We want to help you develop, implement, and monitor a strategy that's designed to address your individual situation. If you are ready to start planning for your financial future, we are here to help. Contact us today at (304) 746 7977 to schedule a meeting with one of our experienced financial advisors or schedule online: https://calendly.com/fourthavenuefinancial/introductory-zoom.