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What are Bonds? How Do Bond Prices Work?

What are bonds?

Investing

What are Bonds? How Do Bond Prices Work?

After completing your investment questionnaire, your financial advisor or brokerage might recommend that you invest a small portion of your portfolio in bonds. This investment option can be an easy way to add diversification and earn a small yet stable income at the same time. But, you are probably asking what are bonds?

What are Bonds?

A bond is debt security that is issued when a government or business borrows money. Bonds are not like stocks that are traded on the Dow or Nasdaq marketplaces where you “own” a small portion of the company. With a bond, you are lending money to the borrower similar to a peer-to-peer loan. Theoretically, you can own stock shares and bond notes in the same company such as AT&T.

Understanding How Bond Prices Work

Several factors influence the price of bonds. You will need to pay attention to the interest rate, supply and demand, and maturity, credit quality, and whether the bond is taxable or non-taxable for starters.

When a bond is selling at a discount, the bond is sold for less than the face value. As an example, a $1,000 bond selling at a 1.5% discount can be purchased for $950.

Bonds selling at a premium are worth more than face value. In this instance, a $1,000 bond with a 1.5% premium is worth $1,150.

A bond selling at par, is selling for the same price as its face value. A $1,000 bond can be purchased for $1,000.

There aren’t any crystal clear answers for if you should only buy bonds selling at par or discount. You need to pay attention to several factors that will be mentioned below.

Just remember, discount bonds might be selling lower because they might be riskier companies. Premium bonds might be sold by more stable companies or government agencies, but, you need a higher yield (interest rate) to offset the higher initial investment costs.

Bond Interest Rates

If you have ever put money in a Certificate of Deposit account at your bank, you already have an insight in how bond interest rates work. When you invest in bonds, interest rates are usually set for a fixed period of time (maturity date) and you will earn that interest rate for the life of the bond.

Bond interest can be paid at regular intervals or when the bond matures. The second option is often reserved for zero coupon bonds sold at steep discounts.

With a fixed rate bond you will earn the same interest rate for the life of the bond. If the bond yield is 3% for a 10-year maturity date, you will earn 3% for the life of the bond.

Floating Rate or Variable rate bond yields can fluctuate. The rate can be tied to the Prime Rate or LIBOR central bank interest rates. Rates fluctuate and can increase or decrease on a quarterly basis.

Maturity Date

Unlike stocks that you can own as long as the company remains listed on the stock exchange, bonds “mature” after a predetermined length of time. You can buy a bond with a maturity date of as short as six months up to 30 years. At the end of the bond term, all the interest payments will have been paid in full and you will receive your initial investment back as well.

Credit Rating

You also need to pay attention to the credit rating of the bond issuer. The best credit rating is AAA and the worst rating can be BB or lower. Bond yields are higher as credit ratings get lower. For example, investing in the United States Treasury bonds have a higher credit yield than the City of Chicago with junk bond status.

Just as you might miss a payment or even default on your student loans or home mortgage, any bond issuer regardless of their credit rating can also default. Sticking with the example of U.S. Treasury bonds and Chicago bonds, the latter is more likely to default according to the credit rating agencies. That’s why interest rates are higher. But, if the agency or company stops making payments, you will no longer receive interest payments and can lose money.

Callable Provisions

You will also want to pay attention to any provisions that come with the bond. These call or put provisions can be very valuable if you plan to sell the bond before it matures.

Call Provisions are normally associated with bonds that have a higher interest rate. They protect the bond issuer (the company or government) borrowing the money if interest rates rise. This means the bond investors cannot sell the bonds if rates rise and force the bond to be “reissued” at a higher price. But, sellers do have the option to call the bond if interest rates drop sharply to sell the bond because it will not yield the originally estimated rate of return.

Put Provisions are for bonds issued with a lower interest rate. If interest rates rise, you (the investor) can call the bond early to get a higher interest rate to earn a higher rate of return than specified in the original interest rate.

Convertible bonds issued by corporations have the option to convert your bond to common stock shares after the bond meets certain maturity conditions. Not every corporate bond will do this.

Taxable Status

One last factor to consider is if the bond is taxable or non-taxable. Select bonds issued by local and state governments are tax-exempt from federal income taxes and your home state (if it issued the bond). You might consider a tax-free bond when you are a “buy and hold” investor.

Where to Buy Bonds

You can buy bonds from your investment brokerage (i.e. Vanguard or Fidelity) for your retirement and non-retirement accounts. It is even possible to trade bond ETFs if you invest with a robo-advisor.

Government Bonds

Admittedly, it will most likely be much easier to buy government bonds. They are more common and you can buy them at the federal, state, or local level. You can also filter between taxable and non-taxable bonds when researching local and state bonds.

Corporate Bonds

Your brokerage might also allow you to buy corporate bonds on an individual basis. However, not every company issues bonds and the selection can be a lot smaller than government bonds.

Bond Mutual Funds

If you want instant diversification or simply don’t want to fool with calculating yield rates or maturity dates, you can invest in a bond mutual fund. These funds invest in government and corporate bonds with differing investment strategies.

Advantages of investing in a bond fund are that the fund manager buys and sells bonds as necessary. And, most bond funds remain open in perpetuity because they are constantly adjusting their ladder of bonds. As bonds mature, they sell them off and buy new ones with a similar maturity timeline.

Related: What is a Mutual Fund?

Bond ETFs

Bond ETFs (Exchanged Traded Funds) have also increased in popularity because they have lower investment minimums and fund fees than similar bond funds. For example, you might need $2,500 or even $10,000 minimum initial investment to purchase a bond fund. Bond ETFs allow you to start with a purchase of a single share. If a bond ETF is selling for $25, you only need $25 and any additional money to cover the trade fee.

Investing with Bond ETFs is a good option when a bond mutual fund is closed. When a mutual fund becomes too big, they prohibit new investors from joining. To offer an alternative to top performing bond mutual funds, bond ETFs with a similar investment strategy and holdings can still be purchased and mimic the performance of the bond mutual fund.

If you invest with a robo-advisor such as Betterment or WiseBanyan, your portfolio will invest in bond ETFs because of their cost-effectiveness.

Related: What is an ETF?

Summary

Bonds are a key part of your retirement investment portfolio as you progress through your working career. Even if you do not invest in bonds now, you will be in the upcoming years. It is important to understand how different bonds function. Federal, state, local, corporate, or international bonds function slightly differently.  By keeping an eye on the price, interest rate, and credit rating, you have a good cornerstone of how to begin investing in bonds.

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