Understand the Basics of Bonds

How to buy bonds

Bonds.  I’ll be honest, I think they’re pretty boring.  They’ve always confused me.  Lots of confusing terminology and calculations.  Now, don’t get me wrong.  Bonds can be great so I shouldn’t give them a bad rap.  They can be a conservative addition to your portfolio to help you offset the risk of your stock investments.  And lucky for you and I, there are plenty of resources available on the internet to help you with calculating all that boring stuff I just mentioned, making it much easier for you to select a bond that’s right for you.  So we’ll just go over some bond basics to help you get started.  This might not be the most glamorous post but definitely one worth reading.  So… are you with me?  Lets do this!

What is a Bond?

Think of a bond as a loan you’re making to a corporation or government entity.  Doesn’t that sound fancy?  Just like you get charged interest on the debt you have from your car, home or credit cards, these entities also pay debt.  So a bond is your chance to get in on the all that interest they’re paying!  Here are some basics terms you need to understand:

Par Value – This is the price of the bond (usually in $100 or $1000 increments) that will get paid back to you when the bond matures.

Maturity – This is the length of time until the par value of the bond is paid back to you.  Maturity of a bond can be in months or years.

Coupon Rate – This is the interest rate the bond will pay until it matures.

Why They’re Great

Bonds balance out a portfolio of stocks because although they tend to offer lower returns, are deemed less risky.  But the stability of bonds will counter the fluctuation of stocks.  The risk you are exposed to with bonds is the risk the bond issuer (the corporation or government you received the bond from) will default on their debt to you.  Each bond is given a rating which reflects the credit rating of the issuer (just like lenders look at your credit score before giving you a loan, credit card, etc.).  The bonds are rated AAA, AA, A, BBB, BB, B, CCC, CC, C, with AAA being the safest bond to purchase and C bonds having the highest risk for default (also known as junk bonds).  Bonds issued by the US Government, called Treasury Bonds or T-bills, are deemed some of the safest out there due to the government’s ability to always pay back its debts on time.

Making Money on a Bond

Your biggest question is probably “how much can I make from bond investments?”  This is where things can get a little confusing.  If you buy a bond at par value and hold it until maturity, it’s easy to calculate how much you’ll get as a return.  If you buy a bond for a par value of $1,000 and your coupon (interest) rate is 6%, $60 will be paid to you on an annual or semi-annual basis and you’ll get your $1,000 back when the bond matures.  However, the prices of bonds are always fluctuating with changes in the market and interest rates.  The current market price of a bond is called its “yield”.  Once you’ve bought the bond, if you plan on holding it to maturity you don’t have to worry about whether the yield continues to change.  You’ll always get what you paid for the bond if you hold it all the way to the maturity date.  But if you need to sell it sooner, this may affect your investment.

How Do I Buy Bonds

You can buy bonds online through a broker.  Many brokers require a minimum bond purchase of $5,000.  If you don’t wish to invest this much in bonds, a mutual fund that specializes in bonds may be a better alternative.  I actually recommend mutual funds that are made up of bonds (or a mixture of bonds and stocks).  Fund managers buy millions of dollars’ worth of bonds at a time so their transaction costs are lower than if you tried to purchase bonds on your own.

Now, if you plan on buying treasury bonds, these are very easy to purchase individually.  You can buy treasury bonds directly from the US Treasury here.  Remember that the earnings on these bonds are also exempt from state and local taxes, which means they earn more than standard bonds of the same coupon rate.

If you really want to understand bonds and their yields better, Investopedia has a great article that offers a more in-depth explanation on the basics of bonds.

 

Photo Credit: US National Archives and Records Administration

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