Bonds

Bonds are a great way for investors to diversify their investment portfolio. They can offer protection against market volatility, and provide a steady stream of income to the bondholder. Bonds can also have different names that can be unfamiliar to new investors, such as fixed income and debt securities, or debt instruments.

Word to know

Principal - the initial amount borrowed, and the face value of the bond, typically principal (face value can also be called par value) is $1,000.

Maturity - when the term of the bond ends, and the borrower returns the principal to the bondholder

Bondholder - the individual who purchases the bond, hence the individual who loans out money to the entity needing capital

Interest rate -the rate in which interest payments are made to the bondholder from the borrow

What is a bond

In lamest terms a bond is an agreement to borrow money for a set period of time, and the bond holder gets periodic interest payments. At maturity the borrower returns the principal to the bondholder, and the bondholder gets to keep all the interest payments. Simple right, well not so much.

Risks of bonds

Bonds can be a safer investment compared to stocks, but that doesn't mean they come with no risk. Bonds have their own risks such as credit risk (default risk), and interest rate risk.

Default Risk

Lets first look at default risk, or credit risk. As the old saying goes, the higher the risk the higher the reward, and a company with higher default risk issuing a bond means the bondholder can potentially make more money. For the higher risk of a company or government agency bondholders are compensated with a higher interest rate. You can potentially make more money holding higher yielding bonds, but the risk of defaulting can be greater. If the bond issuer were to default, you the bondholder lose your invested principal.

Interest Rate Risk

Interest rate risk is the risk that interest rates can rise making your bond less valuable. Lets say that interest rates rise, and you bought your bond when interest rates were 2%, and now lets say interest rates are up to 3% your bond is worth a little less. The reason is because a new investor can buy a higher yielding bond on the market to get a higher interest payment. If you are investing money would you like 2% or 3% return?

If Interest Rates Go Up

To compensate for the lower interest rate than the market, you will have to sell your bond at a discount. Par value that you invested in is lets say $1,000 with interest rate of 2%. Now to compensate a new invest or for the lower interest rate you will have to sell your bond for $666. Here is why: 2% o n a $1,000 principal is $20/year. The new investor will be getting $20, but they need to be making 3%, so investing $666.66 and getting $20 per annum is equivalent to 3%. So go figure what the loss would be in case you needed to sell you bond, $1,000 - $666.66 = $333.34. This is only if you had to sell your bond if interest rates went higher, but if you are comfortable holding that bond then you will continue to collect the $20 a year, and will get full $1,000 back at maturity.

If interest rates go down, then your bond is conversely at greater value. Since your bond is paying a coupon rate of 2%, and lets say interest rates go down to 1%, then your 2% coupon is worth more. Lets say you were to sell your bond in the secondary market, you can demand premium for the bond and sell it more than you paid for it.

Types of bonds

Corporate bonds -issued by corporations, e.x. Apple, Microsoft, Tesla

Governments - Issued by governments to fund projects

Municipalities - issued by municipalities to fund projects

Zero-coupon bonds - bonds that don't pay any interest, instead are sold at a discount. E.g. a $1,000 bond is sold for $800. This bond pays no interest, but the buyer will make $200.

Junk bonds - these are the highest yielding bonds, they have the highest risk of default

Bond Ratings

The big three of bond ratings are Fitch, Moody's, and Standards and Poors. All three have a different method of rating, but usually AAA then AA then A. All the A's are high quality bonds, with AAA being the highest in quality and having the lowest default risk. A is the lowest of the A's, good quality bond, but with a little higher risk. A rated bonds will pay a higher interest rate because they carry more of a risk.AAA rated bonds will pay the lowest interest rates, but are the safest rated bonds.

The same pattern goes for BBB then BB and B, with BBB being the highest rated of the B's. The B's are more risky than the A's, so BBB to B rated bonds pay more in interest.

Then there are the C's. These bonds are below investment grade, they are called junk bonds. These pay the highest interest rates, but are the most likely to default.