Understanding BondsSubmitted by Headwater Investment Consulting on March 11th, 2014
By Kevin Chambers
Many amateur investors have some idea about what bonds are, but do not fully understand exactly how they work. So let me explain the fundamentals of bonds.
If you or I want to buy a house or a car, most of us need to borrow money. We go into our local bank and request a loan. Every year, we pay interest to the bank as a fee for letting us borrow money from them. When companies and governments (also called issuers) need to borrow money, it is usually in very large amounts; too much for any bank to provide. Therefore, they issue bonds to the public. When investors buy the bonds, they are essentially lending their money to the issuer. The issuer then pays the investor for letting them use the money by sending the investor periodic payments called interest payments. The interest rate (also called the coupon of a bond) is the percentage of the total bond the issuer is going to pay the investor. Each investor will receive the original principle investment on the maturity date of the bond. Bonds that have maturity dates farther in the future, say 20 years, get a higher interest rate, because the investor will not get the principle back for a long time and needs to be compensated more than, say, and investor who is only loaning money for 3 months before being repaid.
For example, Sally buys a bond with a face value of $1,000 with an interest rate of 5% that will mature in 10 years. That means, for the next 10 years, Sally will receive $50 a year ($1,000X0.05=$50). After 10 years, Sally will receive her original investment of $1,000. At any point during those 10 years, Sally can also decide to sell her bond to another investor. The price of any bond can fluctuate day to day, just like any other publicly traded security.
Prices of bonds can be affected by many different things. If a company that issues bonds is having financial problems and investors think there is a high chance that they are not going to be able to repay their lenders, the price for their bonds will drop because investors are worried that at maturity, they are not going to get their principal back and want to at least get some of their money back. The risk that the issue of a bond will not be able to make future payments or repay the principal is called default or credit risk.
However, bond prices are most affected by the overall level of interest rates in the marketplace. Bond prices and interest rates have an inverse relationship. As interest rates rise, bond prices fall. Likewise, if interest rates decrease, bond prices will increase. Furthermore, as interest rates rise, the value of already issued bonds at lower interest rates goes down. For example: if you own a bond that has a coupon of 4%, but can go easily purchase a bond that will give you 6%, your 4% bond is not very valuable compared with all of the higher earning bonds in the market place.
As a reminder, Headwater Investments rarely buys individual bonds, but usually buys mutual funds that contain hundreds or thousands of individual bonds. Some bond mutual funds invest in one type of bond, while others invest in various types of bonds. The managers of the mutual fund decide which bonds to buy and sell.