What are bonds? And how do bonds work?

Bonds are seldom as sexy as those wild-ride shares, but they're reliable money-makers. Learn about bonds and how to match them to your personal investing style.

There are a whole bunch of different types of investing one could experiment with. They vary in risk and should typically match your personal investing style. Bonds are great because they provide investors with a stable and consistent income. Learn about the pros and cons of bonds and how they actually work.

What is a bond?

A bond is a debt investment in which an investor loans money to a corporate entity or government. The funds are borrowed for a defined period of time at either a variable or fixed interest rate. If you want a guaranteed money-maker, bonds are a much safer option than most. There are many times of bonds, however, and each type has a different risk level.

Unlike stocks, which are equity instruments, bonds are debt instruments. When bonds are first issued by the company, the investor/lender typically gives the company $1,000 and the company promises to pay the investor/lender a certain interest rate every year (called the Coupon Rate), AND, repay the $1,000 loan when the bond matures (called the Maturity Date). For example, GE could issue a 30 year bond with a 5% coupon.

The investor/lender gives GE $1,000 and every year the lender receives $50 from GE, and at the end of 30 years the investor/ lender gets his $1,000 back. Bonds differ from stocks in that they have a stated earnings rate and will provide a regular cash flow, in the form of the coupon payments to the bondholders.

This cash flow contributes to the value and price of the bond and affects the true yield (earnings rate) bondholders receive. There are no such promises associated with common stock ownership.

After a bond has been issued directly by the company, the bond then trades on the exchanges. As supply and demand forces start to take effect the price of the bond changes from its initial $1,000 face value. On the date the GE bond was issued, a 5% return was acceptable given the risk of GE. But if interest rates go up and that 5% return becomes unacceptable, the price of the GE bond will drop below $1,000 so that the effective yield will be higher than the 5% Coupon Rate. Conversely, if interest rates in general go down, then that 5% GE Coupon Rate starts looking attractive and investors will bid the price of the bond back above $1,000. When a bond trades above its face value it is said to be trading at a premium; when a bond trades below its face value it is said to be trading at a discount. Understanding the difference between your coupon payments and the true yield of a bond is critical if you ever trade bonds.

Pros and Cons of Bonds

As with (almost) all things, there exist both pros and cons when it comes to investing in bonds.

Pros

• Bonds are a fairly safe investment and are created to give you, the investor, regularly pre-scheduled payments
• In case the company fails to pay the promised payments, you have them by the um, tail. You’ll be one of the first to receive compensation for the loss if the company’s assets are liquidated
• Even if interest rates go down, you’re still guaranteed (by law) to receive the higher rate
• Even though selling a bond is not as easy and fast as selling stocks on the stock market, there is a market where you can sell it if you really want to (old school – like calling up your broker and asking him or her to find you a buyer)

Cons

• Tax, Tax, Tax. Interest payments from bonds are taxed higher than any other investment income. It’s based on the tax rate that you pay on your regular income, it does have the potential to be quite high based on your earnings
• If interest rates go up, you’ll be tied to the lower interest rates. This means that if you’re currently receiving 4%, and the market interest rates go up to 6%, you are still locked into the pre-arranged 4%
• While the return is fixed, it is limited. You could make much more money if you invested in something riskier, like stocks or ETFs
• Most bonds pay interest semi annually (twice a year), and some bonds don’t pay any interest until the end (zero-coupon bonds). This isn’t a good thing if you’re looking for something that pays you money more frequently.

How do bonds work?

Companies often issue bonds directly to investors when they’re looking to finance new projects or refinance existing debts instead of obtaining loans from a bank. A bond is issued along with a contract that states the interest rate and when the loaned funds are to be returned.

There are two ways to make money on bonds:

Interest payments

In most cases, you’ll get regular fixed interest payments while you hold the bond. Some bonds do have floating rates fluctuate over time. On the bond’s maturity date, you’ll get back the face value.

Selling a bond for more than you paid

Bond prices tend to go up as interest payments go down. Should this happen, money can still be made by selling your bond before it matures. You’ll get more than you paid for it, and you’ll keep the interest you’ve made up until the time you sell it.

Who should invest in bonds?

Investing in bonds isn’t for everybody. While many experts agree that at least some of your portfolio should be made up of bonds, there are certain types of investors who fit the mold a little better.

You would be more likely to invest in bonds:

1. If you are a relatively conservative investor.

Bonds are considered to be a safer alternative to stocks in the short term. They are less volatile, meaning there will be less swings.

2. If you feel the stock market is too risky and you want to make sure all your eggs aren’t in the same basket

Stocks tend to outperform bonds over time. Though in the short-term, bear markets could cause your stock investments to lose value. However, as the graph below indicates, Bonds have typically been more stable than any other asset.

3. If you cared more about generating income from your investments rather than appreciation.

Bonds pay a regular interest rate (income) but usually do not go up in value as much as stocks, ETFs or mutual funds do.

4. If you are a retiree

Investors in retirement have a shorter investment horizon. Therefore, you will care more about income generation and safety.

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