What is a Bond and How do Bonds Work?

Economy, Investing

A bond refers to a debt security that pledges to make regular payments for a specified period of time. If you are wondering what a security is, it is a claim or entitlement on the issuer’s future assets or income. If you buy a bond, you are simply lending money in return for interest payments which the borrower or bond issuer makes periodically during the loan term. At the time of loan maturity, the bond issuer pays the principal or original amount of the debt to the lender or bond holder. When to pay the periodic payments of the interest and the date of maturity are based on the terms of the bonds agreed upon by both holder and issuer. Bonds are commonly issued by governments and corporations. They do so to raise capital so they can finance their projects or business expansions.  The major bond classifications include the US Treasuries, corporate bonds, municipal bonds, and agency bonds. US Treasuries are those issued by the US Department of Treasury while corporate bonds are offered by corporations that have investment grade ratings. Local governments like states and cities can also issue municipal bonds. Government-sponsored enterprises like Freddie Mac and Fannie Mae can also offer agency bonds. Aside from these, there are also high-yield bonds, asset-backed securities, mortgage-backed securities, and collateralized debt obligations (CDO).

How do selling and buying bonds actually work?

People buy and sell bonds through the so-called bond market, where transactions are mostly done electronically. It is a market that is less structured and organized than the stock market.  Trading bonds are mainly done between entities or institutions. If a client asks a broker to buy bonds for him, the broker would call a certain institution and express the order for some specified bond. The institution would then search for that bond from another institution that may have this particular bond in their inventory. That institution would then produce a quote for the bond which the investor can either agree on or not. A price negotiation may also occur. The same procedure applies when one entity needs to sell a specific bond.

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Return on Bonds

The yield that investors gain from bonds is the rate of interest or coupon, calculated based on the bond’s face value or its worth at date of maturity. The coupon payments can be monthly, quarterly, semiannually or annually. The coupon dates have to be clearly specified in the agreement.  Many people do not wait until the bond reaches its maturity date. To earn money, they trade bonds at the secondary market. This is so because bond prices in the market fluctuate like other financial instruments. If the market price of a bond increases, the holder can sell it at a premium. If the opposite happens, the bond can be sold at a discount.

Why are interest rates on bonds low?

Interest rates on bonds are low, if compared to say potential returns in engaging in the stock market. Since bond issuers can only accept a certain amount of price for their borrowings, the rates are low, after all these are fixed obligations they have to make whether their activities turn to be profitable or not. Bond carries a low amount of risk for investors who give a lot of weight on safety of their money. These safety-minded, risk-averse investors accept low interest rates in exchange for the minimal risk.

How do you invest in bonds?

A bond is a type of investment like a stock. But unlike stocks which are risky and volatile, the returns on bonds are fixed, hence an investor can look forward to a predetermined amount of interest payments. Although sometimes, bonds can be floating-rate bonds which depend on the prevailing market interest rate, these do not fluctuate in the same manner that stocks do. Even so, investors in bonds have to exercise diversification to spread the risks. Also, take note of dealer’s costs when choosing a broker. You may also use a bond fund where an entity or fund manager administers your bond investments. Pay attention to fees and charges. There are also types that are sold with tax benefits, but you need to research about the various issues surrounding these. Make sure all details are clear to your prior to making your transactions. You have to note that changes in the market conditions affect your bond investment unless you are already content with the yield of your bond. Remember, that if you hold it until maturity date, you will get your money plus the fixed income payments.  But if you are using it to maximize your returns, you need to pay attention to fluctuations where the bond price can change. Engaging in the secondary market can be an important way to earn huge profits from bonds.

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Bond Price Formula

Here is the exact formula to figure out a bond’s yield (the price or return you get on a bond if you sold):

Bond prices go up or down depending on the condition of the market. You have to understand this if you plan to trade (buy/sell) the bonds in a secondary market. This means that a bondholder can sell the bonds to another person or entity during the course of the lending period, before maturity. An increase in interest rates tends to decrease the value of a bond that has already been issued. So the bondholder has to increase the price to keep up with the increase in the interest rate. No investor would like to buy a bond through the secondary bond market that pays him only 5% when another can offer him one that would give him 7%. The bondholder then can sell the bond at a discount calculated by dividing the original coupon amount by the prevailing interest rate. For a bond with a face value of $1000 paying an interest of $50 every year, or 5%, the new bond price should be $50 divided by 7%, the current interest rate. This should give a new bond price of $714.28.  In the event that interest rates go down, the new bond price that a bondholder can sell should be higher than the original face value to keep up with the current rate of interest.

Should You Invest in Bonds?

Investing in bonds will depend on your financial goals and risk appetite.  If your financial goal is to aggressively grow your wealth, then bonds will not do it for you.  However, if your goal is to protect your wealth and protect it from inflation, then bonds may be what you need.  Additionally, if your goal is to get annual returns, bonds can also do that as they pay out interest payments semi-annually.

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Typically, if the stock market is doing well, the returns of the bonds will be low.  However, if the stock market is going sour, the value of bonds generally go up.  This makes sense if you think about it in terms of supply and demand.  When the economy is doing well, the stock market generally does well and thus investors are more inclined to invest in companies via stocks.  However, when the economy is going south, investors seek haven in the safety of bonds—therefore driving the value of bonds up.


Comments on this entry are closed.

  • Def

    April 7, 2013, 10:38 pm

    The interest rate on your bonds will stay solid as long as that is the type of bond you puchrased. Some bonds have step rates or zero coupon rates. However, it sounds like you are buying a regular bond that has a fixed percent with a fixed term. Each day, the market price of the bond fluctuates based on its selling and buying values. As long as you hold it to maturity, none of this matters. The only down side for a bond these days is the solvency of the company. Like Lehman Bros. Their bond holders just received a notice that they will get $600 from a $5K investment. Bonds are a fab investment right now. Best investment is a mid term bond that would be held for five years. You can get some good ones out there with a term of five years with a 7 plus percentage return. Anything over five years, plan to hold them for a while. Eventually interest rates will go up and if you need to sell your bond, you may not get the full value.