The Basics Of Bonds

Many investors know they should have bonds in their portfolio to help diversify their investments; but beyond that, their knowledge of bonds gets a little fuzzy. This compilation of several issues of The Financial Advisor will help explain the basics of bonds.

How Bonds Work
Starting with the very basics – a bond is a like an I.O.U. in which investors lend money to the government, a municipality or corporation. In return for the loan, the entity that issues the bond promises to pay a specific rate of interest, plus repay the value of the bond.

There are three basic ways that bonds pay the interest and principal. Most bonds pay regular interest payments over the life of the bond and then pay the principal after the bond has reached a set maturity date. Callable bonds pay investors regular interest payments, but the issuer may elect to “call” the bond and repay the principal at any time. Zero coupon bonds do not make interest payments over the life of the bond, but pay all the interest, plus the principal at the time of maturity.

Maturity Options
A bond’s maturity is the specific date in the future that the investor will receive the principal investment amount. Maturities for bonds usually range up to 30 years in length. Short-term maturities range up to 5 years. Intermediate bonds mature from 5 to 12 years time. Long-term bonds mature between 12 and 30 years time.

Types Of Bonds
Who issues bonds? A variety of entities issue bonds to raise money. The risk and return depends on who is offering the bond. There are five types of bonds issued in the United States:

Government or Treasury bonds – issued by the U.S. Treasury to pay for operating the government and the national debt. The return on U.S. Treasury bonds is the lowest, but they are also lowest in risk.

U.S. Government Agency bonds – issued to fund their agency’s programs, such as farmer loans, student programs or home mortgages. The return is slightly higher than Treasuries and still have low risk.

Municipal bonds – issued by individual states, cities or counties. These bonds help pay for municipal projects and improvements. Yield is on par with government bonds with varying risk. 

Corporate bonds – issued by companies that want to finance new initiatives for their businesses. Both the return and risk of corporate bonds are higher than government or municipal bonds.

Mortgage Backed bonds – issued by banks or mortgage companies to provide money to home buyers. These bonds usually provide a higher return than corporate bonds without much increased risk.

Bonds tend to zig when the market zags, often rising when stocks fall, thereby adding to diversity in portfolios. Bonds fall in between cash and stocks in the risk/return spectrum. They offer moderate risk and moderate returns.

Major Components
Bonds have three major components – face value, coupon rate and maturity.

Face value (or par value) – is the value that the bond holder will receive when the bond matures. If the bond is retired before its full maturity, bond holders may receive a slightly higher face value.

Coupon rate – the annual rate of interest payable on the bond. The higher the coupon rate, the more interest the bond holder receives. The coupon rate is set when the bond is issued and usually does not change over the life of the bond. Most interest rate payments are made on a quarterly basis.

Maturity - is the date established when the issuer will pay back the face value of the bond.

Investment grade-quality bonds tend to be more predictable than stocks. However, investors should be aware that bonds do involve some risk including changes in interest rates, inflation risk and call risk. If you buy a new bond and keep it until maturity, changes in interest and yields aren’t an issue. But when you buy or sell an existing bond, the price that investors are willing to pay for the bond can change, based on the expected return.

Bond Pricing
The price that investors are willing to pay for bonds is impacted by the current interest rates. When interest rates are higher, issuers of new bonds offer higher rates to keep pace with the market. When this happens, investors are less likely to purchase existing bonds, which offer a lower rate, unless the bond price is lowered. When interest rates are falling, this drives the price of existing bonds up, because they offer higher rates. Bond prices are stated in terms of percentage of face (or par) value. So, if the price of a $20,000 bond is 95, that means the bond can be purchased for $19,000 ($20,000 X .95).

Unlike stocks, determining the exact price of a bond can be difficult. Bond pricing is derived by industry providers, so you won’t see a daily listing like those for stock prices. The derived price is calculated by factoring in the coupon rate, maturity, quality rating of the bond and other factors.

Tax Considerations
When it comes to bonds, the general tax difference depends on whether you are investing in individual bonds or bond funds. This impacts how interest income is received and how capital gains are realized. If you hold individual bonds, you are taxed on the interest earned in the year it was received. For bond funds, interest income distributions are calculated regularly and distributed on a monthly basis. So, for bond funds, you are taxed in the year in which the interest accrues.

For individual bonds, if they are purchased in the primary market at the original price and held to maturity, generally a capital gain or loss will not be recognized. If the bond is purchased in a secondary market at a premium or discount, this may trigger a capital gain or loss.

It’s important to remember that your tax liability will vary depending on other considerations. Please consult with your tax professional for complete information.

Diversification Strategies
Diversification is always a good strategy, when it comes to investing. As we detailed in the previous articles in this series, there are many types of bonds available - with different backers, yields and time to maturity. Consider a mixture of U.S. Treasury, corporate, municipal or mortgage bonds.

Another way to diversify your bond holdings is to stagger the maturity dates. Buying a mixture of long-term and short-term bonds, called laddering, which helps to reduce your risk and makes changing interest rates less of a concern. Since only a portion of your bond holdings will be maturing at any given time, you will be able to adjust your portfolio to minimize ups and downs.