This is How Bonds Work

If you have a workplace retirement account, it is highly likely that at least part of your portfolio is invested in bonds. But it is perhaps less likely that you can articulate why that is the case.

Oh, to be sure, you know in a general way that “bonds are less risky than stocks,” because you read that…somewhere. But why is that the case? You may have thousands of dollars — perhaps tens or hundreds of thousands — invested in bonds without really understanding what they are all about. Let’s fix that right now!

In its simplest definition, a bond represents a loan. The entity that is taking out the loan — that is, issuing the bond — is called the issuer. The amount of this loan, the amount borrowed, is the principal. And just like when you and I take out a loan, the issuer must pay interest regularly. That loan has a due date of course, and in “bond world” we call that the bond’s maturity date. So that’s our basic architecture:

• An issuer borrows money by issuing a bond.

• You, as the investor, purchase the bond and receive regular interest payments.

• On its maturity date, the bond will come due, and you (the investor) will receive the amount borrowed (the principal).

Well, that’s all very straightforward. Now let’s get into some of the nitty-gritty.

The most popular of bond issuers are government entities. These may be bonds issued by the US Treasury or by certain US government agencies. State and local governments also issue bonds (called municipal bonds) and foreign governments issue bonds that US citizens can buy. Large corporations also issue bonds, and this is a natural segue to discuss the quality of bond issuers.

The quality of a bond issuer — how likely the issuer is to pay back what they borrowed — is judged by firms (rating agencies) who assign a grade or a rating to each bond issue. Different firms use slightly different terminology (and occasionally they disagree on the merits of an issuer). US Treasuries are widely considered the safest of the safest (i.e., very, very unlikely to not pay up when the bond comes due), followed closely by US agency bonds (like Fannie Mae, Ginnie Mae) and a handful of public corporations. These bonds are rated AAA (or Aaa).

Bonds rated AA (or Aa) are also considered high-quality (not likely to default) and the scale goes down into the alphabet as the risk of the issuer not making good on their debt increases. The cut-off point to keep in mind is BBB (or Baa); below that, the bond is considered to be a “junk” bond, or more politely, a “high yield” issue.

Which brings us to our first key lesson, which I hope is obvious: the lower the rating, the higher the interest rate paid to you by the bond issuer. Risk and reward go hand in hand.

There is another aspect to risk which we must take into consideration. If I borrow $1000 from you with a promise to pay you interest every quarter while the loan is outstanding and repay the principal (the $1000) after one year, you may be very happy to take that gamble and not charge me a lot of interest for the loan. But what if I say that I will pay you back only after five years? I mean, fine, I was good for one year, but I can get up to an awful lot of mischief over the course of five years. Yes, you will still give me the loan, but you will charge a higher interest rate. While the loan is outstanding, I will make higher interest payments which compensates you for the greater risk that I will default in five years.

Lesson Two: The longer the maturity of a bond, the higher the interest rate.

With those basics in hand, let’s move on to the good stuff.

Calculating the price of a bond is a bit complex, but the underlying logic is quite straightforward. And yes, you do need to understand how bonds are priced because when the time comes to buy a bond, you’re going to need this knowledge. So here we go.

Let us imagine that I sell you a bond today for $100 that pays an interest rate of 5% (paid out to you twice a year) until the bond matures in five years. But a few months from now, you decide that you just want to get your $100 back right now, so you ask your co-worker if she wants to buy this bond from you. If, after looking bond prices up online, she sees that not much has changed in the market and bonds paying 5% interest cost about $100, then she will give you about $100 for your bond.

But what if, over those intervening few months, interest rates in the market changed (as they do), and she can go out and buy a bond today that matures in about five years (like yours) from the same issuer, and it has an interest rate of 6%. Now your 5% bond doesn’t seem as attractive, but she will still take it off your hands…but for maybe $90. Alternatively, perhaps the economy is such that now new five-year bonds are being issued with a 4% annual interest rate. In that case, your oldie-but-goodie 5% bond is worth more than the $100 you paid for it.

Our third lesson: Bond prices move in the opposite direction of market interest rates.

And if you reflect back on Lesson Two, the likelihood of something happening that changes market interest rates increases the longer the bond is outstanding.

To summarize, when you own a bond, you face risk from two directions: One, that the bond issuer will go belly-up. Two, that market interest rates will make your old bond less attractive than newly issued bonds. Both of these risks go up the longer the bond is outstanding (i.e., the maturity), and that is reflected in how bonds are priced.

Thus, our fourth lesson: Bond prices jump around more (i.e., are more volatile, up and down) the longer the bond’s maturity.

OK, we are ready now to answer those questions we started with more than 1,000 words ago:

Why do I own bonds in my portfolio? Why are they considered “safer”?

The reason is simply this: If you buy a share of stock, the only way you make money is for the share price to go up. Ok, yes, some stocks pay a quarterly dividend, but most of the time, that is not a big amount. Your primary reason for buying a share of stock is almost always for the possibility of capital gain.

On the other hand, if you buy a bond (and to be clear, I am talking of the high-quality variety here), you can potentially make money in two ways. First, the bond will pay you regular interest payments as we have seen. But secondly, the price of the bond may rise. These two things together are referred to as the total return of a bond.

Now, to be sure, the bond price can fall and if you sell, you will have a capital loss. But as you have picked up those sweet interest payments along the way while you were owning the bond, you still may come out ahead. That’s an oversimplification but in a nutshell, that is why bonds (and particularly high-quality bonds that are not very long in maturity) are considered “less risky” than stocks.

We have arrived at our destination: a rough-and-ready understanding of how bonds work and why you may choose to have them as part of your portfolio. I don’t know about you, but I’m ready for a nap!

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